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Rising Interest Rates Reaching Beyond The Grave

16157458_sLast week I wrote about how the Federal Reserve (the Fed) finally raised interest rates after promising to do so for over a year. I explained how this could impact average Americans, their retirement and their wealth with such things as loans, mortgages, savings accounts and other financial tools relied on by many. But what if you do not need to worry about how these changes will affect your retirement? What if you are more concerned about passing your fortune on to the next generation? What if you are not average?
 
This was the discussion that I had with some folks, Jack and Jody, in my Plymouth office last week. Jack and Jody are 58 and 56, respectively, and have done quite well financially. Jack was a software executive for years, reaping the rewards of the tech boom of the 1990s while Jody stayed home to take care of their three boys. Jack and Jody have begun the process of transferring their wealth to their children and want to learn about additional strategies to do so. They also wanted to know if the Fed’s decision to increase interest rates will affect any potential strategies.
 
About four years ago, Jack and Jody began loaning their three boys money for them to invest. This is a wealth transfer strategy that many people employ; let me explain how it works. Money is lent to an individual and a promissory note is drafted setting forth the terms of repayment. Any net investment return above the interest paid on the loan is effectively a tax-free transfer of wealth. Of course, Uncle Sam gets involved by spelling out the minimum interest that must be paid so such a loan does not get classified as a taxable gift. But that minimum required interest rate is not bad; currently it ranges from about half a percent to 2.5. Jack and Jody charge their boys 1.5 percent interest.
 
But what if rates creep up? A “borrower” will need to earn a higher rate of return to make a profit, right? That possibility makes this strategy less attractive as interest rates rise. So, I suggested to Jack and Jody that they should consider refinancing now to extend the length of the loan and lock in the historically low interest rates for a longer term.
 
We also discussed the possibility of creating a Grantor Retained Annuity Trust (GRAT). I explained in general terms to Jack and Jody how GRATs can be used to pass down an appreciating asset to younger generations without having a potentially large gift-tax hit, giving them a lower estate tax consequence upon their deaths.
 
Generally, a GRAT is funded with an appreciating asset that converts to a stream of income to the grantor of the trust in the form of annuity payments for at least two years. Those payments generally equal the value of the asset when it is transferred to the trust, plus a market-based interest rate established by Uncle Sam. If the asset earns a higher rate of return than the interest being paid from the GRAT, then, essentially, the excess return results in a tax-free gift to the beneficiaries of the trust, in Jack and Jody’s case, to their boys.
 
So I explained to Jack and Jody that if we think interest rates will continue to increase, then they may want to consider establishing a GRAT to lock in today’s lower rates. Doing so will increase the chances that any return on the trust’s asset will result in a profit for their children.
 
I reached out to Geoff Nickerson, partner at the law firm of Oppenheim and Nickerson, LLP in Falmouth, for his thoughts. Geoff noted that while GRATs are useful tools, it is important for clients to understand some key points. “GRATs are irrevocable trusts, meaning that once you set one up, you don’t get to change the terms of the trust,” Geoff pointed out. “The health of the client is also relevant. One of the main reasons to set up a GRAT, from an estate planning perspective, is that if done properly the GRAT will reduce the value of the donor’s estate. If the donor dies during the term of the GRAT, that purpose will be partially defeated.” Great points, Geoff!
 
Jody also told me that she is interested in giving some of their money to charity. She explained to me how she grew up in Dorchester with very little and remembers those who gave to her. So for Jody’s philanthropic mind we discussed moving some of their assets into a Charitable Remainder Annuity Trust (CRAT). A CRAT works in much the same way that a GRAT does, only the ultimate beneficiary is a charity. A CRAT would give Jody the opportunity to name one or more of her charities as the beneficiary of any assets donated to such a trust, while also allowing Jack and Jody to draw income during their lifetimes from those assets.
 
I explained to Jack and Jody that since they would be the grantors of a CRAT, they would receive a tax deduction at the time they fund the CRAT for the present value of the remainder interest that will eventually pass to Jody’s charities.
 
When interest rates are high, the present value of the income stream to a donor is lower. This results in the value of the gift being higher for tax purposes. Basically, the higher the interest rate at the time the CRAT is funded, the greater the tax deduction.
 
Folks, raising interest rates won’t necessarily make a huge difference to your portfolio over the next year, but, as the financial world is ever-changing, so should your financial strategy, which should include a plan to effectively transfer wealth. Make sure you review your current estate plan and see if there are any new opportunities or risks that you need to be aware of with the coming changes.
 
Be vigilant and stay alert, because you deserve more! Have a great week.