Tara Thompson Popernik (in photo) and Stephen S. Schilling
US investors interested in establishing a “zeroed-out” Grantor Retained Annuity Trust (GRAT) would benefit from completing their transactions before rising interest rates diminish its potential value—preferably before the end of July.
The zeroed-out GRAT has been a popular estate-planning vehicle for many years because it can transfer wealth to the next generation while using little or none of the $5.25 million applicable exclusion amount (the money that you can give away either during your life or at death before gift or estate taxes kick in). That leaves all or most of the applicable exclusion available to shelter assets from estate taxes. At an individual’s death, the cost basis for appreciated assets is increased to fair market value, so the potential income tax on the appreciation is eliminated. This “step-up” has become even more valuable with the increase in US income tax rates, effective in 2013.
The key to a zeroed-out GRAT is that the present value of the annuity payments retained by the grantor must equal (or zero out) the value contributed to the GRAT so that there is no taxable gift. Anything remaining in the trust after the annuities have been paid passes to the beneficiary gift tax free. The size of the annuity payments needed to zero out the GRAT depends on interest rates at the time the GRAT is established. Lower interest rates are better because they lower the required annuity payments and thus increase the chances that there will be something left over for heirs.
The Internal Revenue Service sets the required annuity rate for newly established GRATs each month, based on US Treasury yields. The rate has fluctuated from an all-time high of 11.6% in 1989 to an all-time low of 1.0% in January 2013. The July rate of 1.4% reflects Treasury yields from May 15 through June 14, so it does not reflect the recent spike in bond yields; the August rate will.
Based on a methodology we believe to be similar to the IRS methodology, we project that the August rate will be 2.0%, and if current US Treasury yields persist, the September rate will be 2.2%. So, there’s likely to be a significant benefit to completing a GRAT transaction before the end of July.
To give clients a sense of the large impact that interest rates can have on the success of longer-term GRATs, we estimated the remainder value of GRATs established under different historical conditions. In each case, a 10-year GRAT is established with $1 million invested in the S&P 500 Index. For GRATs established in the quintile of months when the 7520 rate was lowest (between 1.2% and 2.6%), the median remainder value would have been about $2.1 million, almost four times the $533,000 median remainder value of GRATs established in the second quintile of months, when the 7520 rate was between 2.6% to 5.2%.*
The good news is that there are still two weeks left to take advantage of the July rate, and the August rate will still fall within the lowest quintile of historical rates. But the window for locking in a low rate for a longer-term GRAT strategy may be closing, as the days of hurdle rates below 2% may be soon be at an end.
*This analysis includes 745 10-year periods, beginning monthly from 1941 through May 2003, using a proxy for the 7520 rate before 1989 based on IRS methodology. All strategies funded with $1 million. All assets are invested in S&P 500. Wealth to beneficiaries is adjusted for inflation over the applicable time horizon.
The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation.
Tara Thompson Popernik, CFA and CFP, is the Director of Research and Stephen S. Schilling, CFA, is a Director in the Wealth Management Group at AllianceBernstein.