Rising Interest Rates Can Benefit Trust Transfers
As the Federal Reserve continues fighting inflation with higher interest rates , clients should know that various trusts can be effective wealth-transfer strategies when rates rise — but also that not all trusts are equally effective .
The performance of trusts as estate planning vehicles is often tied to the federal funds rate , or the “ 7520 hurdle rate ,” says Alexandra Blake , director and wealth advisor at Crestwood Advisors in Darien , Conn . That refers to Section 7520 of the Internal Revenue Code , which says that the interest rate for an annuity in a trust must increase in value at greater than the hurdle rate , which is tied to the market yield on U . S . government debt .
For example , she said , the current applicable federal rate for a mid-term grantor-retained annuity trust ( GRAT ) is around 4.6 %. “ The first 4.6 % of the returns of the underlying investments would be returned to the grantor with the amount above the 4.6 % passing onto the beneficiary .” If the assets in the trust aren ’ t growing as fast as the interest , however , that means more money is passing out of the trust back into the grantor ’ s hands through annuitization .
“ If investment returns don ’ t exceed the hurdle rate , the strategy would fail to move assets out of the grantor ’ s estate ,” Blake says .
Still , she adds , “ It ’ s important to emphasize that there is a very limited downside to most of these strategies . … Even if the investment return doesn ’ t beat the hurdle rate , the only sunk cost is the few thousand dollars to set up the initial vehicle .”
Certain strategies produce greater tax benefits in low-interest-rate environments , says Alan Weissberger , director and portfolio manager at Hirtle , Callaghan & Co . in West Conshohocken , Pa . These include grantor-retained annuity trusts , sales to intentionally defective grantor trusts and charitable lead annuity trusts . On the other hand , Weissberger says , a number of planning strategies are more effective in higher interest rate environments . These include qualified personal residence trusts , charitable remainder annuity trusts and charitable gift annuities , he says .
Different trusts and vehicles offer different benefits when rates change :
• In a grantor-retained annuity trust , or
GRAT , in which the appreciation and return on the assets put into the GRAT equal the amount of the annuity paid out . To pass any remainder to beneficiaries , however , the returns on the appreciated asset must exceed the 7520 rate for the length of the annuity — the unknown factor in a GRAT ’ s effectiveness . Higher hurdle rates mean less to pass on to beneficiaries .
“ In a charitable lead trust , a grantor contributes assets to a trust giving a charity a right to an annuity payment for a term of years .”
— Peter Trieu , Crowe
GRAT , the grantor retains the right to an annuity for a term of years while the remainder goes to various beneficiaries . The value of the remainder is a taxable gift at the time the trust is funded and calculated using the 7520 rate , says Peter Trieu , a partner in private client tax services at Crowe in San Francisco . “ A high interest rate equates to greater value assigned to the retained annuity , making the value of the taxable gift lower ,” he says . This can reach a “ zeroed-out ”
• In a charitable lead trust , “ a grantor contributes assets to a trust giving a charity a right to an annuity payment for a term of years ,” Trieu says . “ The remainder goes to the grantor and / or other beneficiaries . If passing to other beneficiaries , the remainder is a taxable gift . As with the GRAT , the higher the interest rate , the higher the value of the gift to the beneficiary charity , and the lower the taxable gift of the remainder .”
Continued on page 14
MARCH 2023 | FINANCIAL ADVISOR MAGAZINE | 9