Estate planning strategies when interest rates are higher

BDF Website - Oct 20, 2022

For most people, an estate plan’s primary goal is to help ensure assets are allocated to the intended beneficiaries in a fair and efficient manner that lessens the emotional burden imposed on their heirs.

For many, there’s also the goal of reducing taxes. When this is the case, interest rates can play an important role in the level of taxation. Therefore, it’s important to have a general understanding of how interest rates may impact common estate planning strategies. It’s also worthwhile to recognize tactics that are typically most effective in an environment of low interest rates, and those that are usually best when interest rates are higher.

Although interest rates had been sitting at historically low levels since 2010, they have begun to rise as inflation moves higher. Each month, the Internal Revenue Service publishes two important rates that impact certain estate planning techniques: the Applicable Federal Rates (AFR) and the Section 7520 rate. The AFR reflects the minimum interest rate to be charged for loans between related parties in order to avoid a gift tax. The Section 7520 rate is used to calculate annual payments that must be made to the beneficial parties when utilizing various techniques for financial products like annuities. These rates are calculated based on the yields of government debt instruments and the target federal funds rate.

Low-interest-rate environment

Estate planning in a low-interest-rate environment typically includes implementing strategies that transfer wealth to family members with little or no gift tax being owed. These strategies often involve senior family members either lending younger family members money, selling them assets or creating a trust. Applying such techniques provides a predetermined income stream, all in anticipation of the assets being utilized earning a higher rate of return than the applicable prevailing interest rate.

When implemented properly, this technique allows the senior family member to “freeze” the value of the assets being utilized and pass along the appreciation in value to junior family members (outright or in a trust) for their benefit. Examples of techniques that benefit from a low-interest-rate environment include intrafamily loans, Grantor Retained Annuity Trusts and Intentionally Defective Grantor Trusts. The use of Charitable Lead Trusts is a technique that benefits those who are charitably inclined.

High-interest-rate environment

Estate planning in a high-interest-rate environment entails reducing the actuarial value of a future gift that would otherwise be taxable. The higher the prevailing rate, the more beneficial these strategies will be. Qualified Personal Residence Trusts (QPRT) and Charitable Remainder Trusts (CRT) are two common techniques that we’ll consider in turn.

Qualified Personal Resident Trust

With a QPRT, a trust is formed to own a personal or vacation residence with the goal of transferring the residence to the trust beneficiaries when the trust term expires. During the trust term, the grantor may occupy the home as they would otherwise. At the end of the term, they can either relinquish use of the home or rent it back. Since the initial transfer is a taxable gift of the remainder interest, the higher the interest rate, the higher the value of the retained right to utilize the property during the term of the trust, and the lower the value of the gift.

Charitable Remainder Trust

For those who are charitably inclined, when a CRT is formed, a non-charitable beneficiary (typically the grantor or grantor’s spouse) receives a predetermined annual payment from the trust. These payments can be either for their lifetime, for a term of up to 20 years, or the shorter or longer of the two options. A charitable organization then receives the remainder of the trust value at the end of the specified term. The annual payment received is typically a percentage of the trust value, which must be at least 5% and not more than 50%. Moreover, the value going to charity must be at least 10% of the trust’s initial value. In an environment of higher interest rates, it’s easier for the trust to pass the strict IRS guidelines, while at the same time it provides the grantor with a higher charitable income and gift tax deduction.

With interest rates on the rise and uncertainty as to how high rates will go before stabilizing or possibly coming back down, implementation of any interest-rate-sensitive estate planning technique requires guidance from a qualified estate planning expert. Our team can assist you in better understanding the options available to you. We can also work closely with you and your estate planning attorney to help implement the strategies that align best with your personal and family goals.



John Smith, CFP, AEP®

Partner, Wealth Advisor

As a member of BDF's Business Owner Team, John is adept at helping business owners integrate their unique business opportunities and risks into their personal wealth management plan. He finds that business owners, in particular, are often so focused on making sure that their business operations are running smoothly, they may overlook their personal financial well-being. John holds the ACCREDITED ESTATE PLANNER® designation.