Low Interest Rates Present Numerous Wealth Planning Opportunities

Low Interest Rates Present Numerous Wealth Planning Opportunities

by David R. Foster, JD, AEP, CLU, ChFC, CAP, FLMI

One of the few silver linings in the recent economic cloud is that interest rates are at historically low levels. In addition to mortgage refinancing opportunities and low payment obligations on variable loans, low interest rates present an opportunity to take advantage of certain wealth transfer strategies that are more favorable in low interest rate environments. For some historical perspective on just how low interest rates are, consider the effective federal funds rate (EFFR). The EFFR reached a high of 19% in June 1981 but dropped precipitously from 5% to under 1% after the Great Recession of 2007. As of this writing, April 16, 2020, the effective federal funds rate was .05% (not a typo).

Keep in mind that low interest rates in themselves are not a reason to implement a strategy. A family’s personal circumstances, dynamics and goals must be considered as primary factors when choosing to implement a financial or estate planning strategy. But now might be a good time to discuss your goals with your professional advisors to determine if it may be advantageous to strike while the iron is hot.

The following are just a few of the wealth transfer strategies that may achieve better results when interest rates are low.

Grantor Retained Annuity Trusts

One common strategy for transferring wealth while mitigating federal transfer taxes is the Grantor Retained Annuity Trust (GRAT). In simplified terms, parents transfer assets to the GRAT, receive a specified income stream for a period of years (generally 1-10 years), after which the remaining balance in the trust is distributed to selected family members. This strategy is often recommended when the parents wish to transfer wealth to their children or grandchildren, want to avoid estate and gift taxes, but financially need to retain some level of income from the assets transferred, at least for some period of time. When interest rates are low GRATs are generally more successful in transferring wealth free of transfer taxes.

Example: Assume Parents contribute $1,000,000 to a GRAT and that GRAT pays the Parents an annual income of $110,165 for 10 years. Further assume the GRAT invests the money and achieves a net growth rate of 6%. After 10 years the GRAT will distribute the remaining balance of $338,785 to their Children. When the contribution is made the IRS will calculate the value of the future remaining GRAT balance and consider it a gift to the Children. They will base their calculation on an assumed growth rate equal to the §7520 rate. Based on the current §7520 rate of 1.8% (March, 2020), the assumed value of the remaining balance for gift tax purposes would be $0. The Parents would have effectively transferred $338,785 to their Children and completely avoided federal gift taxes (and avoided using up any of their unified gift/estate tax credit). If the §7520 rate was 3.6% (the average rate over the past 20 years), the value of the gift would have been $125,910.

Private Family Loans

Another way to pass on wealth to family members is through the use of private family loans. The IRS generally assumes intra-family loans are gifts. However, this presumption may be overcome as long as the loan is a bona-fide loan and there is a real expectation of repayment. A minimum interest rate must be applied to the loan, known as the applicable federal rate (AFR). Lower AFRs make private loans a more effective wealth transfer tool.  The average mid-term AFR (applicable to loans with a duration of 3-9 years) over the past 20 years is 2.92%, with a high over that time period of 6.71%. The mid-term AFR in March of 2020 was 1.59%.

Installment Sales of the Family Business to Family Members

Owners of family businesses often wish to sell the business, or a portion of it, to younger generations. Since the younger generations may not have sufficient cash on hand to pay the purchase price in a lump sum, sale agreements often allow for payments over a period of time. Such installment sales of business interests to a family member are more favorable for the buyer when interest rates are low since lower interest rates mean lower annual payments.

Charitable Giving Strategies

There are a number of charitable strategies that are more favorable during times of low interest rates. Charitable deductions for gifts of the remainder interest in a residence or farm (referred to as life estate agreements) are greater when interest rates are low. Income tax deductions for contributions to Charitable Lead Annuity Trusts (CLATs) will also be larger when Interest rates are low. CLATs allow the donor to take a current year deduction for future annual charitable gifts, which is often appealing for charitably inclined families that wish to offset a substantial current-year taxable event.

 

The success of the strategies mentioned above rely on various factors in addition to interest rates. The value of the asset, the expected growth rate of the asset, and the life expectancy of the parties involved all may impact the outcome. In addition, each involve various risks, some of which may be managed. For example, the GRAT strategy mentioned above becomes ineffective for transfer tax purposes if the parent (Grantor) passes away during the term of the trust. Life insurance may be purchased on the life of the parent to mitigate that risk. Similarly, if an interest in the family business is sold under an installment sale agreement, and the buyer passes away during the term of the note, the selling family member may be at risk of not receiving the full sales proceeds. Life insurance on the buyer may be appropriate.

 

Low interest rates may provide a window of opportunity to effectively achieve wealth transfer and legacy planning goals. Since 2010 we have been in a period of historically low rates. The Fed had recently announced a number of small increases, but those increases had been reduced over the course of 2019 and were completely eliminated when the global coronavirus pandemic hit. Until the economy recovers from this crisis, the window should remain open, making it a good time to discuss these opportunities.

CARES Act Impact on Wealth Transfer and Business Planning

The CARES Act, signed by President Trump on March 27th, contains a number of provisions relevant to wealth transfer and business planning strategies.

 

  • IRA and qualified plan required minimum distributions (RMDs) are waived for calendar year 2020. The new rule also applies to beneficiaries who received IRA or qualified plan funds and are currently taking RMDs.

 

  • Charitable income tax deduction limits are increased from 60% of adjusted gross income to 100%. The new limit only applies to cash contributions made directly to charitable organizations, not to private foundations or donor advised funds, etc.

 

  • The CARES Act provides a number of provisions aimed at providing cash assistance to small business owners and farmers, including a $9.5 billion aid package for farmers, the Paycheck Protection Program offering potentially forgivable loans to small businesses to maintain their payrolls, additional tax credits for employers who retain employees through December, 2020, and the ability to delay payment of their 2020 social security tax for up to two years.
DISCLOSURES: The information presented does not involve the rendering of personalized investment, financial, legal or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed. Any opinions, projections, forecasts and forward-looking statements presented herein are valid as on the date of this document and are subject to change. Past performance is no guarantee of future performance. As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.