Interest rates rose in 2022 and may continue to rise. Even though interest rates have risen, they remain relatively low when compared to historical rates. Certain wealth transfer strategies use low interest rates to transfer wealth. Even though rates have risen, these strategies may be appropriate in the right circumstances to tax-efficiently transfer wealth.
Many family wealth transfer strategies are more effective when interest rates are low. Although interest rates have risen from their earlier lows, they remain relatively low compared to historical rates. Accordingly, even though interest rates have increased, in some circumstances, it may be appropriate to take advantage of wealth transfer strategies that work better in low-interest-rate environments, such as Grantor Retained Annuity Trusts (GRATs), Charitable Lead Annuity Trusts (CLATs), and intra-family loans.
Below, we review three strategies that perform well in low-interest-rate environments. Every family’s circumstances are unique. A planning technique that might work well for one family may be inappropriate for another. Careful consideration should be applied when considering a financial or estate planning strategy. Always consult your personal legal tax and financial advisors before selecting and implementing any such strategy.
Mitigating Federal Transfer Taxes
The federal estate tax, gift tax, and generation-skipping transfer taxes can be levied when wealth is transferred from one person to another (whether during life or at death). The Tax Cuts and Jobs Act of 2017 (TCJA) substantially increased federal estate and gift tax exclusion levels, but that increase is temporary. Unless Congress takes further action, on January 1, 2026, the increased exclusion amount will return to 2017 levels (approximately halved from today’s amount) indexed for inflation.
Notwithstanding the common desire to save taxes, it is important to understand that each of the strategies discussed below has implications beyond mitigating federal transfer taxes and income taxes. For example, transfers of family wealth may help educate future generations on how to handle wealth, protect assets from creditors, or accomplish a charitable goal.
Grantor Retained Annuity Trusts
One common strategy for transferring wealth while mitigating federal transfer taxes is the grantor-retained annuity trust (GRAT; see GRAT Example). The success of a GRAT relies in part on trust assets growing at a rate that exceeds the IRC § 7520 rate (7520 rate), which is influenced by then-current interest rates. A low 7520 rate maximizes the potential for success of a GRAT, with success being measured by the amount of wealth transferred with the lowest federal transfer tax, if any, being paid as a result of the transfer (Table 1).
Sam and Emily Smith would like to transfer assets to their children, but have already used their lifetime gift tax exclusion. They would, nevertheless, like to avoid paying any gift tax when the transfer is made. A GRAT may be designed so the Smiths will receive annual distributions from the trust, pass on the remaining assets to the children in 10 years, and avoid being subject to gift tax. (Although the payment made to the Smiths each year may increase by 20%, this example uses a level payment.)
10-Year, level payment, $1 Million Grantor Retained Annuity Trust*
|Sec. 7520 Rate||Annual Distribution to Grantor||IRS Value of Remainder for Gift Tax Purposes||Actual Remainder to Family (Year 10)|
|4.8% (November 2022)||$128,250||$0.02||$201,228|
|6.0% (for comparison)||$135,868||$0.07||$95,672|
|8.0% (for comparison)||$149,029||$0.04||$0|
* “Zeroed-out” 10-year GRAT initially funded with $1 million. Annual distribution to grantor based on creating a zero (or near zero) gift tax value. Assumes 3% income and 4% growth on GRAT principal. Some values have been rounded.
Source: Internal Revenue Service, PNC
Another way to pass wealth to family members is through the use of loans. However, the IRS generally assumes intra-family loans are gifts.
This presumption may be overcome as long as the loan is a bona-fide loan and there is a real expectation of repayment (Private Loan Example). In addition, a minimum interest rate must be charged on the loan, known as the applicable federal rate (AFR). The AFR is influenced by current interest rates. The borrower may invest the loaned assets such that the return the borrower receives is greater than the interest paid on the loan (Table 2).
Kevin and Joan Miller would like to transfer wealth to their children who have a number of business opportunities. They want to avoid paying gift taxes and have used their lifetime gift tax exclusions. Instead of making gifts to their children, they could make loans. A loan of $1 million, with interest-only payments followed by a balloon payment in year nine, may provide the Millers with a means for transferring wealth to their children free of gift tax. (Note: the Millers will report as income on their income tax return the interest they receive from the children.) The lower the applicable federal rate, the lower the interest on the loan (Table 2).
$1 Million Private/Family Loan Example
|Mid-Term AFR (Annual Compounding)||Interest Paid Annually||Balloon Payment (End of Year 9)||Net Amount Available to Junior Generation after Payment of Loan*|
|3.97% (Mid-Term AFR, November 2022)||$39,700||$1,000,000||$362,933|
|6.0% (for comparison)||$80,000||$1,000,000||$119,780|
|8.0% (for comparison)||$149,029||$1,000,000||($119,780)**|
* Assumes 7% growth on loaned assets less interest paid. Using appreciated assets to repay the loan could cause a capital gain. This illustration does not take income tax attributable to loan interest or income tax on capital gains into consideration. Some values have been rounded.
** This result moves wealth from the junior generation to the senior generation.
Source: Internal Revenue Service, PNC
Charitable Lead Annuity Trusts
Families that wish to financially support the missions of charitable organizations or advance other philanthropic goals may seek to maximize the tax advantages of their charitable gifts. For those who plan to make consistent annual charitable gifts, a Charitable Lead Annuity Trust (CLAT) may provide a number of advantages. One of the tax benefits of a CLAT could allow the donor to receive a current- year income tax deduction for charitable gifts that will be made in the future (CLAT Example and Table 3).
Jennifer Jones, a 65-year-old widow, has regularly supported charitable organizations in her community. Jennifer has an estate potentially subject to the federal estate tax. Jennifer would like to continue giving $50,000 each year to charity for the rest of her life; and, following her death, she would like to pass property to her children and pay the least amount of estate tax. Jennifer may be able to accomplish these goals by contributing $1 million to a lifetime 5% CLAT, with $50,000 distributed to charity annually and the remainder passing to her children after her death without a federal estate tax being paid on these assets. Jennifer may also be able to take advantage of a current year income tax deduction, even though most of the payments to charity will not be made until future years. Note that a lower 7520 rate generates a greater possible income tax deduction (Table 3).
$1 Million Lifetime Charitable Lead Annuity Trust*
|Sec. 7520 Rate||Annual Payment to Charity||Remainder to Family (Life Expectancy)*||Possible Current Year Income Tax Deduction**|
|4.8% (November 2022)||$50,000||$1,616,804||$549,010|
|6.0% (for comparison)||$50,000||$1,616,804||$496,505|
|8.0% (for comparison)||$50,000||$1,616,804||$425,935|
* Assumes trust has a 7% total return. To potentially receive a charitable deduction for the present value of the annuity in the year the CLAT is created, the trust must be a grantor trust. As a grantor trust, Jennifer will report the CLAT’s income on her income tax returns and pay the associated income tax. The income tax consequences to Jennifer are not illustrated in this example. Some values have been rounded.
** Subject to limiitations regarding deductibility imposed by the Internal Revenue Code.
Source: Internal Revenue Service, PNC
The strategies discussed above are just a few of the ways to use interest rates in the wealth transfer and planning process. Other options may be available depending on your particular goals and circumstances.
For example, installment sales of business interests to a family member or a trust for family members are more favorable for the buyer when interest rates are low. It is important to seek the advice of professional advisors familiar with your specific goals and financial situation before engaging in any tax strategy. Even though interest rates have risen and may continue to rise, your circumstances may provide an opportunity to effectively achieve your wealth transfer and legacy planning goals using an interest rate sensitive planning technique.