A Not So Distant Sunset
The gift and estate tax exclusion currently stands at a lofty $12.06 million per person ($24.12 million per couple) on an inflation-adjusted basis. Yet wealthy families may still face a dilemma when it comes to transferring assets without a large tax bill. Absent future Congressional action, higher exemptions will be halved in 2026 with the scheduled “sunset” of the Tax Cuts and Jobs Act provisions.
In the meantime, investors have many wealth transfer options at their disposal—though some work better than others depending on prevailing interest rates. With rates persistently low in recent years, many clients have benefited from Grantor Retained Annuity Trusts (“GRATs”) and installment sales to Intentionally Defective Grantor Trusts (“IDGTs”). Each represents a “freeze strategy” that allows the principal to grow more than a stated interest rate, and to be transferred over time while avoiding or minimizing the use of the applicable exclusion.
The main difference? GRATs are investment vehicles that allow grantors to fund a portfolio for the benefit of their descendants, in exchange for a series of annuity payments based on the prevailing Section 7520 rate—an interest rate based on current Treasury yields that’s used to value future gifts.1 At the end of the trust term, any remaining funds are transferred to the descendants free of gift or estate tax.2 While the duration of such trusts vary, short-term GRATs are frequently structured as “rolling,” so that outgoing annuity payments fund new GRATs into the future.
With installment sales to IDGTs, many practitioners recommend a small gift to the trust prior to the sale, which may require the grantor to use some of their lifetime exclusion. After the small gift is made, the bulk of the assets are sold to the trust in exchange for a promissory note committing to payments back to the grantor.
How Rates Factor In
That’s where rates come in. Generally, the fixed interest rate charged on promissory notes must be at or higher than the applicable federal rate (“AFR”) when the note is issued. The Treasury Department resets the AFR monthly based on daily Treasury yields. As Treasury securities have steadily climbed over the past few months, so too have their related AFR and Section 7520 counterparts.
What does this mean for interest rate–sensitive transfer techniques? Rising rates eat into the return available for future beneficiaries once interest and annuity payments have been made. Consider that a 3% increase in the AFR results in 71% percent less wealth transferred over a nine-year installment sale in a globally diversified equity portfolio. Ultimately, executing wealth transfer strategies while interest rates remain low may yield a significant advantage.
Handling Higher Rates
How well would these wealth transfer strategies work in a rising interest rate environment? We simulated the expected wealth transferred on a $1 million portfolio using two popular strategies:
- a series of 2-year term “rolling” GRATs across a nine-year period of rising rates, and
- an installment sale to an IDGT over nine years. For the IDGT analysis, we then compared three separate scenarios: the current AFR and higher rates of AFR +1% and AFR +3%, respectively.
From an economic perspective, the rolling GRAT strategy at the prevailing AFR would be a better choice than the installment sale to an IDGT (Display). That’s especially true for the AFR + 1% and AFR +3% scenarios, where the benefits decrease dramatically. The rolling GRATs also win out for those more concerned with the likelihood of success (i.e., the probability of effectively transferring a specific level of wealth).
These results may seem counterintuitive in a rising rate environment. Yet, all these strategies tend to thrive when the prospects for near-term asset appreciation exceed prevailing interest rates—a possibility even when rates are relatively high. Their “all-weather” nature makes rolling GRATs or IDGTs a versatile strategy that can play a role in many estate plans.
Room to Maneuver
Wealth transfer can flourish under a variety of interest rate environments. For the strategies discussed here, keep the following in mind:
- Rolling GRATs: These are surprisingly successful, even in a rising rate environment (as our analysis ensured by rolling annuity payments into future GRATs with higher 7520 rates). That’s good to know as, on average, we expect the 7520 rate to increase over the next nine years with a one in four chance of rising above 5.8%.
- Installment sales: These are much more sensitive to starting interest rates compared to rolling GRATs, so locking in today’s low rate is critical.
With interest rates expected to continue their upward climb, it’s best to avoid procrastinating. Taking advantage of today’s low rates to implement wealth transfer strategies can enhance wealth distribution to future generations while significantly reducing future estate tax.
- Pavan W. Auman
- Director, Tax & Transition Strategies—Wealth Strategies Group
- Robert Dietz, CFA
- National Director, Tax Research—Investment & Wealth Strategies
1 If the annuity interest is a “qualified interest” within the meaning of the Code, then the present value of that interest, discounted at the Section 7520 rate, is subtracted from the value of the initial contribution to the trust to determine the amount of any taxable gift.
2 Although any wealth transferred should avoid both gift and estate tax, generation-skipping transfer (GST) tax may apply if the beneficiaries are “skip persons,” such as the grantor’s grandchildren. The GST exemption, which can be used to avoid the GST tax, cannot be applied to a GRAT until the end of the annuity term. See Code § 2642(f).