On Dec. 12, 2012, the Federal Reserve publicly stated its commitment to keep interest rates at near historic lows until unemployment rates are less than 6.5 percent. (Given that the Fed projects unemployment will remain at least 6.8 percent by the end of 2014, all signs point to a low interest rate environment that could last well into 2015). A sputtering economy, the possible expiration of Bush-era tax cuts, and reduced gift tax exemptions have created a sense of urgency for maximizing gift tax benefits and similar estate planning tactics in 2012. Low interest rates also signal an opportunity to leverage grantor retained annuity trusts (GRATs). Here?s the basic overview of what a GRAT is, and why it may be a viable estate planning tool for you and your beneficiaries.
Who can benefit from a GRAT. With a GRAT, a person holding wealth (the grantor) transfers assets to a trust for a relatively short number of years that the grantor can feasibly live through. (Ten-year GRAT?s are common). For the course of the stated term, the grantor receives an annuity from this irrevocable trust. In turn, the payments reduce the gift?s value. When the term concludes, the remaining assets are passed to the designated beneficiaries. Assuming the grantor outlives the trust term, the GRATs remaining principal is not included in the grantor?s taxable estate, which ultimately maximizes asset value for both the grantor and the beneficiary.
The role of interest rates. The inherent value of a GRAT is that assets are valued based on the Section 7520 rate, which is a discount tax rate set monthly. In December 2012, it is 1.4 percent; it reached 6.2 percent in 2006 when the interest rate environment was high. In the case of GRAT?s, there is an inverse relationship between the interest rate used to discount the annuity and the valuation of the retained interest. When the Section 7520 is low, present value of the retained interest is higher, and the remainder interest falls. Given that relationship, establishing a GRAT when the Section 7520 rate is low is the best time to maximize its benefit.
The importance of term. Though interest rates are key in leveraging GRATs, the duration of the term and amount of the annuity are pivotal, too. Assuming the grantor outlives the trust term (the ideal scenario), retained interest is transferred to the beneficiaries with no additional gift penalties. However, if the grantor dies before the term is complete, all or part of the GRAT assets can be included in the overall estate value and are taxed accordingly.
Though a weak economy and low interest rates aren?t ideal for your portfolio, there are opportunities to be found in the other components of your financial and life-plan. A well-designed estate plan can retain more of the wealth that you have accumulated. Sophisticated strategies, such as GRAT(s) are one of many estate-planning tools worth considering with your RAV Financial advisor in our current rate environment to maximize wealth.
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