Inflation in the United States has been near a 40-year high since the start of 2022. To combat this inflation, the U.S. Federal Reserve Bank is aggressively raising interest rates to limit the supply of money and bring down the costs of goods. While the Federal Reserve is likely pursuing the right course from a monetary policy perspective, these rising rates are having a real impact on numerous aspects of the economy. Mortgage rates are increasing, housing values are coming down, and small businesses are having a harder time securing affordable financing. But beyond these often-discussed impacts, rising interest rates may also have a substantial impact on high-value estate planning.
A good portion of tax-sensitive estate planning centers on predicting how much assets will grow over time. To this end, every month the IRS issues the 7520 rate, an assumed rate of growth of all assets for tax purposes. Generally, the 7520 rate increases whenever the Federal Reserve increases interest rates. The following table shows the monthly 7520 rate for 2022:
|7520 Rate for 2022|
As an expected rate of growth, the 7520 rate is clearly artificial and generally does not represent the actual return an investor can make in the market. Moreover, for most estate planning strategies, the 7520 rate is locked in at the time a structure is created and implemented. Locking in a low or high 7520 rate can have a remarkable impact on the effectiveness of an estate planning structure. Some structures become much more effective as the 7520 rate rises, and some structures lose their effectiveness altogether.
A Grantor Retained Annuity Trust (“GRAT”) is a mechanism for individuals to pass assets out of their estate without incurring the gift tax, or using up either the lifetime exemption or annual exclusion. The actual workings of a GRAT are rather technical, but generally a GRAT can pass asset growth out of an estate without incurring a tax consequence. The only real limitation on a GRAT is that it can only pass growth out of the estate that exceeds the 7520 rate at the time the GRAT was created. This means that GRATs are far more effective when the 7520 rate is low than when it is high. To illustrate, an individual has $10 million in assets that grow at 6% per year. If that individual puts those assets into a GRAT in February, he or she would pass 4.4% of the growth out of the estate tax free every year. The same GRAT created in August is limited to 2.2% passed outgrowth. GRATs are much better tools in low interest rate environments and may struggle to be effective in the current economic landscape.
Conversely, a Charitable Remainder Uni-Trust (“CRUT”) is far more effective when interest rates are high. A CRUT is an arrangement whereby an individual and a charity essentially share a pool of assets donated by the individual. The individual takes a stream of distributions—principal and income both—from the assets for a stated term first, and the charity gets all the remaining assets second. Because of the charity’s presence, a CRUT is a tax-exempt arrangement, and all the assets split between the individual and charity grow tax free. However, the amount that an individual can receive from the CRUT during its term is limited by a sophisticated calculation that includes the 7520 rate. Suffice to say, the higher the 7520 rate, the more an individual may take from the shared pot. Because of their tax-exempt status, CRUTs can be powerful tax planning tools, and they become even more valuable when interest rates are high.
Similar to the CRUT, a Pooled Income Fund (“PIF”) is a pool of shared assets between an individual and a charity. PIFs are established by charitable entities themselves—such as universities and community foundations—and are rare these days. With a PIF, an individual contributes assets to a fund run by the charity, the income generated by that fund is distributed to the individual for a set term, and the charity gets the remainder at the end of the term. Notably, the individual contributing to the PIF may take a charitable deduction based on the amount that is expected to go to the charity at the end of the term. When calculating the charitable deduction, the value of the income expected to be returned to the individual—often based on the 7520 rate—is excluded deduction. Therefore, the lower the 7520 rate, the higher the charitable deduction. However, as the PIF runs, if the 7520 rate increases, the actual income distributed to the individual may increase as well, without affecting the already taken charitable deduction. As such, PIFs are at their most effective when the interest rate starts low but rises over time. Indeed, an individual who put money into a PIF in February should be reasonably happy with both the deduction and the return come August.
Other estate planning tools such as intra-family notes and private annuities can also be affected by the Federal Reserve’s Actions and the 7520 rate. Not all estate planning tools work well at all times. For more information on estate planning, check out our Web Tax Planning Guide.
When you are ready, an LBMC estate planning professional will be available to discuss what structures and strategies may help you accomplish your goals in the current economic environment. We look forward to hearing from you.