How to Take Advantage of Low Interest Rates Before They Rise Any Further

Interest rates are now going up – do you know what this means for your estate planning and how you can still benefit from historically low interest rates?

The Federal Reserve has begun raising interest rates. And while rates are historically extremely low, they’re probably at the start of a long, gradual increase. As a result, you might want to consider some estate planning techniques now that benefit from the very low rates because an opportunity like this one might not come around again for many, many years.

Here are some ways to use the current low-rate environment to transfer assets to your heirs while avoiding estate and gift taxes:

Family Loans. One idea is to loan money to a trust for your children, and then have the trust use it to make investments – or make a promising investment yourself, and then loan that asset to the trust. In return, you’ll get a promissory note in which the trust promises to repay the loan with interest.

The IRS specifies a minimum interest rate, which you must observe in order for this arrangement to be considered a non-taxable loan rather than a taxable gift. However, this interest rate is near the lowest point it has ever been. As a result, you can charge minimal interest, and any investment returns above this rate will go to your children without being subject to estate or gift tax.

Installment Sales. If you want to sell a family business to a trust for your children, you can arrange to be paid in installments. This is often a good idea, because the trust can use the profits from the business to pay you off over time, rather than taking out a costly bank loan.

Again, you have to charge interest to the trust in order for the IRS to treat the delayed payments as an installment sale rather than a gift. But the requested interest rate is very low, which means more assets will go to your children free of gift tax.

Grantor Retained Annuity Trusts. You can put assets into a “grantor retained annuity trust,” or GRAT, and then receive income from the trust (that’s the annuity) for a certain number of years. When the trust expires at the end of the term, the assets remaining in the trust go to your beneficiaries.

Here’s why this is good: Let’s say you put $1 million worth of assets into a 10-year GRAT, and at the end of that time the value of the assets has increased to $2 million. If you have simply kept the assets for 10 years and then given them to your heirs, you’d be subject to gift tax based on the $2 million. But if you put the assets into a GRAT now, your gift tax is based on the present value, or $1 million. But even better, that $1 million is further reduced by the present value of the income stream you’ll receive over the 10 years. And here’s where interest rates come into play – when the required IRS interest rate is very low, as it is now, the present value is much higher, and your taxable gift is much smaller.

There’s one large drawback to GRATs, which is that if the donor dies before the term of the trust expires, the trust assets are added back into the donor’s estate, and the tax advantages are lost. For this reason, choosing the term of the trust requires some thought. The longer the term, the greater the tax savings, but the greater the risk that the donor will pass away and the savings will be lost.

There are several ways to hedge against this risk. One is with “layered GRATs.” For instance, instead of setting up a 10-year GRAT, a donor could put 10% of the assets into a two-year GRAT, 10% into a three-year GRAT, 10% into a four-year GRAT, and so on until there are 10 GRATs. Then, if the donor died halfway through the term, the family would still get half the tax benefits – and the donor could lock in today’s low interest rates for all the GRATs.

Another option is to set up a short-term GRAT (say, two or three years) with an annuity that’s equal to the present value of the GRAT assets. As a result, there’s not estate or gift tax at all. With interest rates being so low, the trust has to pay very little interest to the grantor – and any appreciation in excess of the interest goes to the family beneficiaries tax-free.

Charitable Lead Trusts. These are trusts that make a payment to a charity each year for a certain number of years, after which the remaining assets go to your family beneficiaries. They’re similar to GRATs, except that the annuity goes to a charity, and your get a charitable deduction.

Some people like this idea because it’s a way to benefit a charity right now, in your lifetime, rather than after you pass away. Charitable lead trusts are a good idea when the interest rates are low, because low rates mean both larger charitable deduction and a smaller gift tax on the assets that go to your family.