ADJUST YOUR ESTATE PLANNING

FOR HIGH INTEREST RATES AND INFLATION

Prices are rising everywhere. From milk and eggs to gas and electricity, everything is more expensive. As of January 2023, the United States’ annual inflation rate was 6.5% after having reached a high of 9.1% in June 2022. These are the highest rates since the late 1970s.

To fight inflation, on February 1, 2023, the Federal Reserve (“Fed”) raised its interest rate from 4.5% to 4.75%, its highest level in 15 years. When the Fed raises interest rates the IRS soon follows. In March 2023, the long-term annual Applicable Federal Rate (“AFR”) will be 3.74% (compared to 2.14% in March 2022). 

This rise in interest rates means that the estate planning strategies we were using in 2021 and early 2022 have grown somewhat stale. One goal of advanced estate planning is to outperform interest rates to move assets to the next generation, which is easier to do when rates are low. However, when rates start to rise, we have to deploy different strategies to adjust to our new reality.

For example, many planners often used the Grantor Retained Annuity Trust (“GRAT”) in a low interest rate world because the GRAT is tied to the IRS’s interest rates. In a GRAT, a Grantor contributes an asset into an irrevocable trust and retains an annuity for a term based upon the IRS’s interest rates for the month the GRAT is formed. The property remaining in the GRAT at the end of the annuity term often passes to the remainder beneficiaries free of gift and estate tax.

If the GRAT outperforms the interest rate, which is easier to do when rates are low, then the GRAT is “successful” because there will be property available to the remainder beneficiaries after the term. If the GRAT does not outperform the interest rate, which is more likely in our inflationary world, then all the property will be paid back to the Grantor and the GRAT will “fail.”

This same idea applies to other popular planning strategies based upon loans and sales to trusts. When the interest rates are low, these strategies are very effective, because it is easier for the borrower to use the cash to beat the interest rate. But when the interest rates are high, these strategies are less successful.

How Can You Adjust Your Estate Planning

Techniques to Account for Inflation?

For one, consider gifting, an often-used strategy to reduce a taxable estate. If inflation is making everything more expensive, then you should be using it to your advantage. The IRS allows for an “annual exclusion” for gift tax purposes, which means that you have a certain amount you can gift to as many people as you like free of any estate or gift tax consequences every year.

From 2018 to 2021, the annual exclusion was $15,000 and in 2022 the annual exclusion was $16,000. Because inflation has become so pervasive, in 2023 the annual exclusion jumped to $17,000. This means that in 2023 you can gift up to $17,000 to as many people as you like (think children and grandchildren) free of any tax consequences. If you are married then you and your spouse can gift as much as $34,000 per person (receiving the gift) in 2023.

The same idea applies to the estate tax. As mentioned in one of our previous newsletters, in 2022, you could have gifted or passed on to the next generation $12.06 million for an individual or $24.12 million for a married couple. In 2023, the number jumped to $12.92 million for an individual and $25.84 million for a married couple. (In New York, the basic exclusion amount jumped from $6.11 million in 2022 to $6.58 million in 2023.) This massive jump on the federal level of almost a million dollars is a direct result of life with higher interest rates.

Second, to the extent you are charitably inclined, another technique that is advantageous in a high interest rate environment is the Charitable Remainder Trust (CRT).

The basic concept of the CRT is similar to a GRAT in that property is transferred to an irrevocable trust for a non-charitable beneficiary for a term (based on current interest rates). Whatever is left in the CRT after the expiration of the term (which must be at least 10% of the fair market value of the initial contribution) is paid to the designated charitable remainder beneficiary. The present value of the charitable remainder interest is deductible as a charitable contribution.

There are many things to like about CRTs, particularly in a world with high interest rates. When prices are inflated it often means that investments are inflated. This means that when you sell a particular investment, the capital gains tax could be high because the investment has an inflated value. With CRTs, capital gains can be a non-issue because they are generally exempt from capital gains. Moreover, the higher the interest rate, the higher the value of the charity’s remainder interest, which means your charitable deduction is higher.

A third strategy to consider in a high interest rate environment is the Qualified Personal Residence Trust (QPRT). This strategy has taken a back seat to GRATs over the years because it is generally not effective when interest rates are low. However, now that interest rates are spiking, this strategy is ready for a comeback.

The basic QPRT concept is one whereby you gift your home to a trust for a term of years. You can live in the home during the term without having to pay rent. At the end of the term, the home is transferred to the remainder trust beneficiaries. You can continue to live in the home, this time paying fair market rent to the new owners, without the rent eating into your gift & estate tax exemption.

The advantage of the QPRT is that the amount of the gift is discounted (based on the trust term and the interest rate at the time of the gift) to account for the Grantor’s retained interest. Now that interest rates are higher, there are more taxable savings to be had in forming a QPRT. In one of our upcoming newsletters, we will delve into the details in creating a QPRT and why you would want to consider a QPRT to help mitigate estate taxes.

The Trusts & Estates attorneys at Pashman Stein Walder Hayden understand that the current inflationary environment in March 2023 is much different than it was in March 2022. Our goal is to make sure your estate planning solutions are tailored to your particular situation. If you have further questions about estate planning in a high interest rate world then please reach out to us and we will help you navigate planning opportunities for March 2023 and beyond.