Four Estate Planning Strategies for a High Interest Rate Environment

Jul 22, 2022 10:00:00 AM


Four Estate Planning Strategies

Interest rates have been climbing steadily throughout 2022, as the Federal Reserve System continues to battle an inflation rate that recently reached a forty-year high. This economic environment lends itself to certain estate planning strategies that take advantage of high interest rates. Keep reading to learn which estate planning tactics are best when interest rates are elevated.

Following the Movement of Interest Rates

While mortgage rates have climbed 2.5 percentage points since the beginning of the year, estate planners are more interested in the applicable federal rate (AFR) and the Internal Revenue Code (I.R.C.) section 7520 rate, which is 120 percent of the AFR. The continuing presence of inflation is stoking fears of a recession, which could bring interest rates back down. However, if the economy does not move toward a recession and interest rates remain high, the following estate planning tactics should be kept in mind.

1. Qualified Personal Residence Trust

A qualified personal residence trust (QPRT) allows the client to transfer a personal residence to their beneficiaries. The grantor can continue to live in the home during the term of the trust. When the term expires, the home is transferred to the beneficiary. The grantor can continue to live there while paying fair-market rent. As the section 7520 rate increases, so does the value of the donor’s interest in the occupancy during the initial term of the QPRT. This, in turn, reduces the value of the taxable gift to the beneficiary.

2. Charitable Remainder Annuity Trust

A charitable remainder annuity trust allows the grantor to receive an annuity for a period of years, with the charity receiving the remainder at the end of the term. That gift can be an income tax deduction if it meets the minimum value set by the Internal Revenue Service (IRS). A higher section 7520 interest rate will increase the value of the gift and could help it to pass muster with the IRS.

3. Swapping Assets

The strategy of swapping assets involves removing low-basis assets from an irrevocable trust and replacing them with high-basis assets. By removing the low-basis assets from the trust and holding the assets in a manner that would cause inclusion in the individual’s estate, the low-basis assets can receive a basis adjustment at the individual’s death under I.R.C. section 1014. An alternative to asset swapping is the grantor purchasing the assets to remove them from the irrevocable trust.

4. Back-Door Roth IRA

Since 2010, investors have enjoyed the opportunity to create back-door Roth individual retirement accounts (IRAs). This involves rolling over funds from a traditional IRA into a Roth fund. The purpose is to get around the income restrictions that the federal government places on Roth IRAs. The Biden administration tried to curtail the use of back-door IRAs, but that change did not happen because the Build Back Better Act stalled in the Senate. Here are three ways to set up a back-door Roth IRA:

  • Place money into a traditional IRA and roll it into a Roth IRA
  • Convert an entire traditional IRA into a Roth IRA
  • Roll over a 401(k) account into a Roth IRA

Keep in mind that an investor can only convert one IRA conversion per year. To avoid the 10 percent early withdrawal penalty, the investor must wait until the age of 59.5 to access the assets in most cases. The IRS has not given official guidance on back-door Roth IRAs

A back-door Roth IRA may be a good idea for clients who earn more than the current Roth annual income limits, which are $144,000 for single people and $214,000 for married couples. Their biggest advantage is that the funds can be withdrawn tax-free without required minimum distributions. The conversion will trigger a tax on the appreciation, but the funds will then grow tax-free. 

An increase in interest rates can lead investors to sell stocks and cause the price of stocks to decline. A down stock market is an ideal environment to convert to a Roth account, as it allows a higher percentage of the retirement account to be converted using the same amount of tax dollars. In other words, by converting to a Roth IRA during a down market, you can shield a larger percentage of your assets from future taxation.  

Keeping an eye on the direction of interest rates and the overall health of the economy will help you decide whether to employ one or more of these strategies. Some of these techniques are advisable only in high interest rate environments, so you may want to take advantage of them while you have the opportunity.

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