Estate Planning in a Rising Interest Rate Environment

By Mark R. Parthemer and Sasha Klein
Rise of Interest Rates

Rise of Interest Rates

T he frightening memories of 18 percent interest rates! Could they be returning? Not yet. But, after more than a decade of interest rates trending steadily lower, interest rates are poised to rise and probably will rise in the foreseeable future.

A rise in rates affects many things: borrowing costs, stocks, bonds, and even currencies. Rates also have an effect on estate planning strategies. This doesn’t mean that estate planning will be any less effective or less important than it has been. It does mean that any particular approach may need to be modified. Some strategies work well when interest rates are lower; some are more effective when interest rates are higher. It is also important to consider where a client is in the estate planning process — in the contemplation stage, in the midst of planning, or having already implemented a plan and transferred wealth. It could make sense, for instance, to wait to implement a strategy. Alternatively, locking in today’s low rates or reengineering an existing strategy could be the best approach.

The taxation of estate and gift planning is tied to interest rates. In this article, we briefly discuss interest rates and their importance to estate and gift tax planning. Then we explore several of the most popular wealth-transfer strategies and when they are most (and least) effective. Now is a great time to speak with your clients, whatever their situation, to review their existing plan (if any)—and to help come up with the best approach, which considers the prevailing and likely interest-rate environment.

Interest Rates and How They Affect Planning

How are estate and gift tax planning strategies tied to interest rates? With the recent upward trend in interest rates, many are predicting a return to normalcy, with rates rising closer to historical averages, fueled in part by the recent pattern of periodic quarter-point increases of the federal funds rate by the Federal Reserve.

Federal Funds Rate (FFR)

The FFR is the interest rate that banks charge each other for short-term loans. It is one of the principal tools the Federal Reserve uses to influence the economy and achieve its goals of full employment, stable prices, and moderate long-term interest rates.

But what does the FFR have to do with other interest rates—and with estate planning specifically? Quite a lot. Typically, an increase in the FFR has a chain-reaction effect on long-term rates. Basically, when the Federal Reserve raises the FFR (inter-bank lending), banks also raise their prime rate—the lowest rate banks can offer for mortgages and loans (customer lending). Among other things, an increase in the prime rate will increase costs for mortgages, car loans, business loans, and other consumer loans. The change in long-term rates affects corporate bonds and asset prices, including the equity markets. It thereby also has an effect on the two primary interest-rate metrics used in the taxation of gifts and bequests: the Section 7520 rate and the applicable federal rate (AFR).

The Section 7520 rate. This is the minimum required rate for several estate planning strategies. It is often referred to as the “hurdle rate” because certain common planning strategies depend on investments returning more than the 7520 rate to be successful–so they tend to be most effective when the 7520 rate is low.

The 7520 rate is recalculated by the IRS every month. It is equal to 120 percent of the then-current midterm AFR rounded to the nearest two-tenths of one percent. For June 2019, the Section 7520 rate stands at 2.8 percent.

The 7520 rate in its current form was established on May 1, 1989. Since then, the average rate has been 6.0 percent. The above chart reflects the monthly rates, with a trend line. Recently, the rate has been trending higher, but we have not been at or above the average rate since January of 2001 (the year the Baltimore Ravens won their first Super Bowl, a stamp cost 34 cents, and a gallon of gas cost just a little over a dollar).

This chart reflects by color and shading those periods with above-average (green) and below-average (red) 7520 rates.

The Applicable Federal Rate (AFR). The AFR represents the minimum interest to be charged on loans to avoid triggering imputed income or gift taxes. Certain wealth-transfer strategies that use the AFR to determine the present value of future payments are more effective when rates are higher. Essentially, a higher AFR will mean a lower present value—and, consequently, lower tax obligations.

The Mathematics of Gifts and Taxes Gift tax value often is based on the “subtraction method,” by which the taxable gift is determined by subtracting the computed value of the retained interest from the fair market value (FMV) of the transferred asset:

FMV – value of retained interest = taxable value or charitable deduction value.

The value of the retained interest is determined using an interest-rate factor (the AFR or 7520 rate).

For example, in a Qualified Personal Residence Trust (QPRT), a donor places her home into a trust but retains the right to live in it for a designated period. The higher the interest rate, the higher the value of the retained right to live in the home, which results mathematically in a smaller (more taxpayer-friendly) gift:

FMV of the house – computed value of retained right to live in it = taxable gift.


The AFR is trifurcated into short, mid, and long term, and it is based on the average interest rate for relevant yields on similar-duration Treasury obligations. For June 2019, the short-, mid-, and long-term annual AFR rates are 2.37 percent, 2.38 percent, and 2.76 percent, respectively.

With very limited exceptions, the interest rate applicable when the strategy is put in place remains effective for the duration of the structure. For example, the 7520 “hurdle” rate for a grantor retained annuity trust (GRAT) is captured when the trust is funded, and that rate remains in effect for that GRAT regardless of its duration. Interestingly, the IRS announces the rates for a succeeding month around the 20th of the preceding month. The rate announced, say, on May 20 will be effective for June transfers. This can make the last week of each month a window of opportunity to implement certain strategies.

Which Strategies for Which Rate Environment?

Planning Impact

Rising rates can have a significant effect, no matter where a client is in the estate-planning process—(1) thinking about planning, (2) in the midst of planning, or (3) has all planning complete.

(1) Contemplating estate tax planning: Crafting an effective estate plan can be a complex process, depending on your client’s financial situation, the nature of his assets, and a host of other client-specific factors. Interest rates are an additional—and critical—factor that should be considered, preferably sooner rather than later. For any current estate planning, it’s important to focus on the ideal structures for the intended beneficiaries, including charities. Once the best strategy is determined, the major decision is whether to implement such a strategy now or risk economic performance while waiting for interest rates to rise.

For example, if you wish to put a CRAT in place with a financially stable asset, perhaps it would be sensible to wait until rates are higher. If, instead, you are considering using an asset (such as pre- IPO stock) that may experience substantial increase in value in the short term, it may be sensible to fund the CRAT at the lower rate so as not to miss the “pop” in performance.

(2) Midst of planning: Revisit the structures being put in place with your clients, which could be particularly important for intra-family loans and sales to grantor trusts. The reason is that these strategies may include interest-only (or older AFR) promissory notes. It may be possible to refinance the notes now, regardless of their due date. The result would be to lock in the current interest rate for a new (longer) term, protecting the note from being restated when rates are higher.

For example, perhaps the loan was made in 2012 with a nine-year term to capture the mid-term AFR. It thus comes due in 2021, when interest rates may be meaningfully higher than they are today. You could refinance the balance (or most of it) for a new nine-year term, beginning in 2019 and not coming due until 2028. Further, we are in a less-than-common economic period with a “flattening yield curve,” which in oversimplified terms occurs when the yields of longer and shorter duration bonds are disproportionately close to each other. One consequence is that the AFRs are less disparate than typical. As a result, it might be possible to refinance a shorter-term note for a longer term with less than the typical leap in the minimum interest rate.

Also, if you are currently doing GRATs, you might consider establishing a series of what we refer to as “shelf GRATs.” These are GRATs established under current law and rates, and then placed in reserve, or “on a shelf,” to be used if and when favorable. An example may help illustrate this concept. A rolling two-year GRAT program subjects each renewal to the then-present 7520 rate. If the rate is up at that time, it creates a higher “hurdle” for this strategy (and its success). But, along with a two-year GRAT funded with an asset you expect to appreciate significantly, you also create a series of mid-term GRATs with, for example, four-, six-, and eight-year terms, and fund them with low-volatility assets (e.g., fixed income). As we mentioned above, these mid-term GRATs will retain the (presumably) lower hurdle rate. In later years, if the 7520 rate is up substantially (or if the law has changed to disallow short-term GRATs), you could take one of the mid-term GRATs “off the shelf” and swap in the volatile asset in exchange for the bonds. This would place the (hopefully) appreciating assets in a GRAT subject to the more favorable earlier rate and law.

(3) Completed Wealth Transfers: If a client has transferred all the wealth she wishes to, at least for now, you should still review the strategies to see if the new tax law or higher interest rates may have an adverse effect on ultimate transfers. Because of numerous changes in the relevant tax law, this review should cover the effect of the temporarily increased exemptions, any formula clauses, and an analysis of capital gains or basis. The higher exemptions may cause an imbalance in a client’s intended bequests. For example, a gift in a will “to my grandchildren an amount equal to my GST exemption” drafted in 2003 would have transferred $1 million had death occurred that year versus $11.4 million if in 2019—and now imagine how the spouse and kids would feel if the decedent only had $11 million!

With formulaic split-interest transfers or increases in bequests that are interest-rate sensitive, rerun the numbers to ensure they pass a higher interest-rate stress test. For example, did you include in your client’s estate plan a CLT to be funded with an amount that equals her GST exemption? With higher exemptions and higher AFRs, will the amount that goes to charity and then to grandchildren be what your client intended?

With the reduction in the estate tax rate and the changes to the income tax laws, it is now more important than ever to include income tax planning, especially capital gains, within the estate plan.

Consider a client who established an irrevocable grantor trust into which assets were gifted or sold. These trusts are designed to hold assets that are outside the taxable estate. The benefits include protecting the appreciation on these assets from the estate tax – and their entire future value from heirs’ estates, potentially for many generations (e.g., in Florida, for 360 years).

However, one trade-off is that there will not be a “step up” in basis for assets in the trust upon the client’s death. In contrast, assets in a client’s estate will receive a step up (or step down) in basis equal to their fair market value upon a client’s death. In many cases, we find that the assets in the trust have grown in value and thus have significant unrealized capital gains, and assets remaining in a client’s name have high basis, often because they include cash and fixed income.

It may be possible to use a swap or substitution power to exchange the high-basis assets for the low-basis assets, positioning a step up. If the exchange is for an equivalent value (e.g., $2 million of cash in client’s name (in the estate) for $2 million of highly appreciated securities in client’s irrevocable trust), there will be no income tax on the exchange, but a free basis step up at client’s death.

Other forms of basis management, including the exercise of powers of appointment or even decanting, also can be used to achieve greater tax efficiency for completed planning.

Conclusion: Speak with Your Clients

Rising interest rates effect our lives, including estate planning strategies. This article has described the basic characteristics of some of the most popular wealth-transfer strategies and when they tend to be most efficient. But the optimal wealth-transfer strategy for a client entails many more considerations. The decision to implement a new strategy today, to wait to reengineer one already in place, or to leverage the benefit of one already completed needs to be assessed in the full context of the client’s circumstances and objectives. It is crucial to weigh the potential benefits of different strategies to determine concrete actions to ensure that the maximum amount of a client’s wealth will be transferred efficiently to those persons and causes they wish to support.


By Mark R. Parthemer and Sasha Klein

Mark R. Parthemer is senior fiduciary counsel at Bessemer Trust Company, and Sasha Klein is a partner at WardDamon, PL.