As everyone knows, the ups and downs of interest rates can have a significant impact on the price of your home, the value of your investments, and what you pay for loans. But rates can also play a big role in estate planning. Indeed, when it comes to many popular types of trusts and other estate-planning techniques, even small moves in interest rates can make a big difference in what you'll be able to pass along to your heirs -- or what you'll have to fork over to Uncle Sam. "It's simply a question of knowing which technique works better depending on the interest rate," says Blanche Lark Christerson, a managing director at Deutsche Bank (DB ) Private Wealth Management.
If you're setting up a trust, the key interest rate is the so-called 7520 rate. The Internal Revenue Service recalculates that rate every month, and it's based on recent auctions of three- to nine-year U.S. Treasury notes (type "7520 rate" into a search engine). At 5.4% in January, this rate has nearly doubled since July, 2003, when it was 3%. As a result, the sorts of trusts that do best in a higher-rate environment -- including ones that transfer real estate and benefit unmarried couples -- are getting attention after years on the back burner. "It's time to sound the bell and say these strategies are attractive," says Michael Duffy, senior director at Mellon Financial's (MEL ) Private Wealth Management Group.
But while the 7520 rate is way up, it's still relatively low by historic standards. So estate planners say it's not too late to get in on trusts that thrive in lower interest-rate environments. "We're telling clients to have the documents ready so they can pull the trigger before rates move higher," says M. Holly Isdale, head of Lehman Brothers (LEH ) Wealth Advisory group.
Of course, when shopping for a trust, your decisions should hinge not just on interest rates but also on factors such as the kind of assets you wish to transfer to heirs, the degree of control you'd like to maintain over your wealth, and whether you want to leave something to charity. Consider your age and health, too, since many trusts return their assets to your estate if you expire before they do.
Here's a look at the impact interest rates have on various popular trusts and other estate-planning techniques.
-- QUALIFIED PERSONAL RESIDENCE TRUSTS (QPRTs)
The beauty of the QPRT is that it freezes your home at its current value and allows you to transfer any future appreciation to your heirs free of gift and estate taxes. The higher interest rates are when you set up a QPRT, the better, since this minimizes the value of the gift you make to your heirs. That, in turn, reduces the amount of gift tax you'll pay or -- if you haven't already used any of the $1 million you can shield from the gift tax -- the portion of this credit you'll use.
When you set up one of these trusts, you remain the home's owner for as long as the trust is in effect -- typically, about 10 years. Then, when the trust expires, the home passes to your children.
To see how it works, suppose you're 60 and your property is worth $1.5 million. When you put your house into a QPRT, the value of the gift to your heirs is based on the home's $1.5 million value. But the home won't actually pass to your children until the trust expires. So, the law allows you to discount the $1.5 million you're transferring to your kids by a current interest rate -- the 7520 rate. This tells you the current value of the gift you'll be making in the future. For that 60-year-old, this discounting -- at January's 5.4% 7520 rate -- knocks the value of the gift to $740,000, says Deutsche Bank's Christerson. If the 7520 rate were 8% instead, the gift would be only $580,000.
You may be tempted to delay a QPRT in the hope that rates will climb. Be careful: If you don't outlive this trust, the full market value of your home will be included in your estate. In part to lessen this risk, couples should consider separate QPRTs, each funded with their half-interest in the home, says Christerson. Another risk: If your home's value falls, you can't reduce the value of the gift you've made.
Since your home will belong to your heirs when the trust expires, be prepared to move or pay rent. But rent can be an effective way to transfer more to your heirs.
-- RETAINED INCOME TRUSTS (GRITs)
GRITs, which also benefit from higher rates, are good estate-planning tools for those who want to leave money to more distant relatives -- not to spouses, children, and grandchildren but to nieces, nephews, and cousins. This trust is also frequently used by unmarried couples when one wants to be sure the other is provided for.
In general, these trusts are funded with securities. During the term of the trust, any interest and dividends earned must be paid out to the person who sets it up. Getting something back sounds good, but people tend to fund these with securities that pay little income. Why? The more capital you can keep inside the trust, the more there will be for the heirs, says Don Weigandt, a wealth adviser at JPMorgan Private Bank (JPM ) in Los Angeles. Provided you're still alive when the trust expires, the money will go to your beneficiaries without passing through your estate.
Just as with the QPRT, you'll have to pay gift tax on the portion of what you put into these trusts that's destined for your heirs. But as the 7520 rate rises, the discounted value of that gift falls, reducing the tax bill you'll pay (or the portion of your $1 million gift trust exclusion you'll use). There's no set term for these. But if you're young, you might want to let one run a while -- say, 20 years. That will save on gift taxes because the trust's current value will be discounted over more years.
-- CHARITABLE REMAINDER ANNUITY TRUSTS (CRATs)
Suppose you have a big block of stock that you bought years ago at a fraction of today's price. You want to diversify that holding, but you don't want to trigger a huge capital-gains tax bill. As long as you also want to leave some money to a charity, the charitable remainder annuity trust could be a good solution.
Here's how it works. Put the stock into a CRAT and you no longer own it. But because the trust benefits a charity, it is a tax-exempt entity and so it can sell the stock without paying taxes. It then can reinvest the proceeds in a diversified portfolio.
You retain much of the benefit from the investments. Indeed, these trusts are required to distribute a fixed amount -- at least 5% of their initial value -- to you each year, potentially for as long as you live. Then, at your death, what's left goes to charity.
How do rising rates make these trusts more attractive? When you set up a CRAT, you're entitled to take a tax deduction on the portion that's destined for charity. As interest rates rise, the assumption is that the trust's earnings will, too. Because the amount you get is fixed at the outset, the IRS assumes there will be more money left for the charity -- and so your charitable deduction today will be based on a higher amount.
-- GRANTOR RETAINED ANNUITY TRUSTS (GRATs)
These trusts fare best when interest rates are low. But if you expect an asset you own to appreciate significantly, it's probably still worth setting one up today.
To see why, consider someone who puts $1 million of company stock into a GRAT. To avoid triggering a gift tax bill, the person who sets up the trust, say, a father, must agree to take back the entire $1 million plus interest calculated at today's 7520 rate of 5.4% over the life of the trust.
The point? If the GRAT appreciates by 10% a year, the owner will take back the first 5.4 percentage points. But the heirs will receive the rest -- or 4.6 percentage points each year, tax-free. After two years, this $1 million trust would amass $74,200 for heirs, calculates Stephen Parker, a wealth adviser for JPMorgan Private Bank in Atlanta. And because the owner takes back everything he gave, there is no gift tax.
If rates rise, however, the payoff declines. For example, if this same GRAT is set up when the key rate is 7.4%, it would yield just $42,000 to heirs after two years, Parker says. One trick: If you think interest rates are heading up, set up a long-term GRAT to lock in today's 5.4% interest rate. "With rates trending up, I'm hearing talk about five-to-seven-year GRATs," says Duffy.
You can also use loans to pass money on to your beneficiaries. The lower the interest rate, the better the deal. To turn the loan into an estate-planning device, rather than simply a favor to a relative, borrowers have to invest the money in something that earns enough to repay Mom or Dad and leave a profit. They can even use the loan to buy an asset from Mom or Dad. Provided that asset earns more than enough to repay the loan, the heirs can pocket the extra appreciation. The IRS permits relatives to lend money at the "applicable federal rates" it sets monthly. These are far below the rates on commercial loans and even below the rate on a GRAT. As a result, you should be able to transfer slightly more to heirs with a loan than with a GRAT.
Current rates on family loans range from 4.29% to 4.64%, depending on your loan's maturity. If rates continue to climb, that's going to look like a good deal.
By Anne Tergesen