Inflation comes with rising prices. It also brings rising interest rates. Bad news if you’re looking for a new mortgage or a refinance.
You can earn 9.62% risk-free on as much as a $10,000 investment in Treasury I Bonds made through October.
Changing interest rates also alter tax-motivated strategies. For those fortunate enough to be concerned about the estate tax, higher interest rates reduce the benefits of a common tax strategy called a Grantor Retained Annuity Trust (GRAT).
In 2022, an estate tax is owed for those with more than $12.06 million of assets. With no change in the law, this threshold may drop to approximately $6.6 million in 2026.
If these numbers are a concern, one strategy is to gift assets before death. The gift reduces what can be transferred at death, but also shifts future appreciation in transferred assets out of the estate.
An asset worth $5 million today could be worth almost $20 million in 15 years if it grows at that 9.62% current I Bond rate.
A gift today could then shift $15 million out of the estate. A GRAT can allow retention of an income stream for the donor’s benefit.
The GRAT acronym has four letters. The “grantor” is the person who owns the property. The “retained” means the grantor keeps some of the benefit from the property.
The “annuity” refers to the amount of the retained benefit. The “trust” refers to the form of the transfer.
Assume a grantor puts the $5 million asset in a trust. The terms say that the grantor retains the right to annual payments of $400,000 for 10 years.
After 10 years, the trust terminates and the property passes to the grantor’s children. Assume the assets are worth $20 million in 10 years because they grow at about 14.4% each year.
The GRAT means the gift is less than $5 million. The grantor “kept” some of the asset, specifically the $400,000 (8%) annual payment.
Retaining $400,000 for 10 years means the grantor will keep a total of $4 million. The tax law says to reduce the amount of the gift by the retained payments.
A simple analysis would say the gift is only $1 million ($5 million minus the retained $4 million).
Because the retained income is paid over 10 years, it must be “discounted” to its present value using a “discount rate.”
Picking a discount rate can be very tricky. The tax law simplifies the process by publishing a rate to use. This rate is based on Treasury yields and changes monthly.
If we didn’t discount the retained payments, they would be worth $4 million. As we discount the value of the retained payments, the gift value rises.
In January, the rate was 1.6%. In May, it was 3%. In July, it is 3.6%. As rates rise, the present value of the retained payments drops. This means the GRAT gift computation rises as rates rise. If you act on a GRAT in July, you can choose to use the July rate, or the rate from either of the preceding two months. You would select the May rate.
For estate tax worriers, the two most important aspects of a GRAT are (1) selecting an asset with “high” growth potential and (2) outliving the GRAT term.
The GRAT saves taxes if trust property grows at a rate more than the published discount rate. It’s not too hard to find an asset that can beat the 3.6% rate.
If the grantor dies when the GRAT is still in force, the full value of the asset is included in the taxable estate.
In the end, it’s a math problem. Picking a higher retained payment reduces the taxable gift. However, if not needed, it also may cause the payments to build up in the estate to be taxed at death.
A longer trust term discounts the retained payments more, and allows the asset to grow more. It also raises the risk that the grantor will not outlive the trust.
If you are worried about the estate tax, either now or in the future, have someone crunch the numbers to see if a GRAT is great or not.
James R. Hamill is the director of tax practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.