On June 15, 2022, the Federal Reserve announced a 0.75% increase in the federal funds rate with another 0.75% rate increase in July expected. The funds rate is expected to rise to 3.4% by the end of the year, with further increases in 2023 possible. Estate planning strategies are particularly sensitive to interest rate movements, mainly because the valuation of assets for gift, estate and income taxes is determined by the IRS valuation tables, which are tied to the federal funds rate. It is worthwhile to consider those strategies that are affected negatively and those that are helped by the rise in interest rates.
Broadly speaking, interest rates are especially relevant when there is a split interest used in the strategy. A split interest is where the present beneficiary of an asset is different from the remainder beneficiary. Split interest strategies include private annuities, life estates, term interest, remainder interest and reversionary gifts. The value of either the present interest and the remainder interest in the asset is determined by the IRS valuation tables and the Code Section 7520 interest rates, both of which are tied to the federal funds rate. Even modest interest rate increases can have significant tax consequences.
The strategies that are hurt by higher interest rates include private annuities, Grantor Retained Annuity Trusts and Charitable Lead Annuity Trusts. In all three cases, the grantor is gifting the future value of an asset to another, while retaining the right to a current annuity either for themselves or, in the case of a CLAT, for charity. In all three cases, the rise in the interest rate when the annuity or trusts are created, means that the annuity rate needed to eliminate the gift tax or maximize the charitable deduction must be higher also.
For example, if John, age 65, transfers property worth $1 million to his daughter, Martha, at the current 7520 rate of 3.6%, Martha will need to pay out $6,704.45 per month, for John to avoid having the transfer being considered a taxable gift. Now if the rate rises to 5%, Martha will have to pay out $7,550.03, a 12.6% increase.
For a Grantor Retained Annuity Trust, with similar terms and amounts, the annual payout at 3.6% is $71,453, but at 5% the annual payout is $82,320, a 15% increase.
The strategies that are helped by a higher interest rate include Grantor Retained Income Trusts and Charitable Remainder Trusts. Grantor Retained Income Trusts for family members are only really useful if the property in the trust is nondepreciable illiquid assets—for example, vacant or agricultural land or artwork and collectibles. This is because the increased interest rates increase the value of the present interest retained by the grantor and so decrease the value of the taxable gift of the remainder interest. Similarly, on a Charitable Remainder Trust, the higher interest rates means that when the IRS calculates the assumed rate of return for the assets in the trust, it will use a higher interest rate, which in turn increases the payout rate for the variable or fixed annuity retained by the grantor.
For example, if John gives $1,000,000 to a Charitable Remainder Unitrust, the payout rate with a 3.6% rate is 19.525%, while the payout rate for an interest rate of 5% is 19.685%.
The likely rise by 0.75% in July means that if you are planning on using a private annuity, a GRAT or a CLAT, you should do so now to lock in the current 3.6% rate. If you are planning on a GRIT or a CRT, then it might be best to hold off until after the rate hike, or even until the end of the year, to fund the trust.
Matthew Erskine is managing partner at Erskine & Erskine.