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, 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” 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 hurtle 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,” 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.”
• The qualified personal residence trust involves the transfer of a home to a trust. Here, “the donor retains the right to live [in the house] for a fixed term, after which it passes to the donees,” says David Handler, a Chicago-based partner in the trusts and estates practice group of Kirkland & Ellis LLP. The current 7520 rate is a main factor in the favorable estate tax treatment in valuing the gift of a residence. The trust freezes the value of the taxpayer’s residence when the trust is created, lowering eventual taxes.
• A charitable retained annuity trust allows grantors a stream of annuity payments for a term of years with the remainder going to charity. The 7520 rate is used to calculate the value of the remainder interest passing to charity. “A higher interest rate equates to a greater gift to charity, providing a larger income tax deduction,” Trieu says.
• Charitable remainder trusts are not for wealth transfers but to defer or avoid income taxes and to benefit charity. “The donor contributes assets and receives payments for a term or for life, after which the assets pass to charity,” Handler said. Higher interest rates during the life of the trust mean that the donor receives larger payments while preserving the gift to charity, he added.
With a charitable gift annuity, Weissberger adds, a contract between a donor and a charity allows a donor to make a gift to the charity in exchange for a fixed stream of income. The charity invests the annuity assets; at the end of the donor’s life, the charity receives the remainder of the gift. Charitable gift annuities “provide a larger charitable deduction when interest rates are high,” Weissberger said.