Financial advisers lamenting the return to low interest rates have one reason to appreciate the move: Falling rates can help wealthy clients transfer more assets tax-free to heirs.
The Federal Reserve's recent interest-rate cut, its first since the financial crisis, and a steep decline in yields on benchmark 10-year Treasury notes have
proved negative for returns on cash accounts and insurance products, but are a plus for clients using a specific kind of
trust known as a
grantor-retained annuity trust.
Uber-wealthy families use GRATs to remove wealth from their estate and transfer it to heirs, who inherit the wealth tax-free. It's the equivalent of making a tax-free gift.
Many well-known people and families — the Trumps, the Walton family of Wal-Mart fame, Facebook CEO Mark Zuckerberg, casino czar Sheldon Adelson and former
Goldman Sachs chairman Lloyd Blankfein, for example — have
set up these trusts, which can help transfer assets such as real estate and business interests.
The key is to transfer an asset that's expected to appreciate in value. And that's where interest rates tie in.
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GRATs have a specific term, maybe five years, over which the asset owner receives an annual annuity payment. By the end of the term, the owner will have received payments equal to the original value of the asset, plus any appreciation up to an
interest rate set by the
Internal Revenue Service.
Heirs receive what remains — any growth that exceeds the interest rate set by the IRS. If the asset's growth doesn't exceed the interest rate, known as the Section 7520 or "hurdle" rate, nothing is transferred to the heirs.
So a low-interest-rate environment makes it more likely that a GRAT's growth will exceed the hurdle rate (and that something will therefore transfer to heirs) and that heirs will receive a greater share of assets tax-free.
The IRS rate has fallen significantly since the beginning of the year, to 2.2% in September from 3.4% in January.
"The lower the hurdle rate, the more that will be transferred to [beneficiaries]," said Charlie Douglas, head of HH Legacy Investments, an Atlanta-based family office. "It's come down 120 basis points. The strategy is making even more sense now than it did."
Here's an example provided by
Northern Trust Wealth Management that uses a two-year, $5 million GRAT whose principal grows at 5%. A trust formed in January would have made annual distributions of $2.6 million to the grantor and transferred $125,000 to heirs tax-free after two years. While the annual distributions from a trust formed in August would be roughly the same, the "remainder" that goes to heirs would be $218,000 — a 74% increase.
"It's a positive time to fund GRATs," said Suzanne Shier, chief tax strategist at
Northern Trust Wealth Management.
The recent market sell-off also bodes well for GRATs, Ms. Shier said.
While the Dow Jones Industrial Average was up 11% this year through Aug. 26, that is down from the Dow's gain of more than 17% in mid-July. A lower stock value leaves more headroom for the asset to grow when it rebounds, meaning heirs could get more of a tax-free gift.
There are a few caveats to the GRAT strategy. For one, the grantor needs to outlive the trust's term for there to be a tax-free transfer — otherwise everything remaining in the trust would pass back into the grantor's estate.
Secondly, the 2017 tax law's increase in the estate and gift tax exemption may lessen a GRAT's appeal for some advisers and clients, Mr. Douglas said. The law
doubled the amount that individuals can transfer tax-free out of their estate during their lifetime, to $11.4 million for singles and $22.8 million for married couples.
That exemption is set to revert to its prior threshold in 2026 unless lawmakers intervene. Estate planners may prefer to take advantage of the current higher threshold now by having clients gift assets out of their estates, instead of using the GRAT vehicle, before the exemption reverts to the lower threshold in seven years.
However, if history is a guide, advisers don't need to be hasty in this regard, Mr. Douglas said. When the gift tax exemption has been raised in the past, lawmakers have ultimately maintained it rather than let it revert, he said.
