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Advisor Perspective

Advisor Perspective

Financial Planning in Higher Interest Rate Environments

Tim Stringer

Principal, CFP®
For Tim, the most rewarding aspect of being a financial advisor is reaching that “aha” moment with clients when there’s mutual recognition of their goals – and then building a road map for achieving them together.

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Over the last several years, interest rates have risen dramatically affecting both short and long-term rates. In recent months, the Federal Reserve has indicated their plan to reduce interest rates several times in 2024 and 2025, rather than continue the interest rate hikes of the last several years. Some people have forecast that this will eventually bring down long-term rates as well.

While the ultimate pace and degree of the reductions are unknown, now may be a good time to review certain planning strategies that benefit from higher interest rates.

How do interest rates impact financial planning?

Many planning strategies involve some type of loan, interest, or payment between one party and another. There is a minimum interest rate that must be applied on these transactions, which is dictated by the Internal Revenue Service. These are known as the Applicable Federal Rates (AFRs) and Section 7520 Rates. The IRS publishes these rates monthly, and they adjust depending on the interest rate environment. These rates have increased considerably in the last few years.

In some situations, such as loaning funds to a child for a home purchase, you would presumably want the IRS-mandated rates to be as low as possible. This would reduce the interest portion of the loan, therefore lowering the child’s monthly payments (or, if the debt is being forgiven, allow you to forgive more principal and less interest each year).

Other strategies benefit from today’s higher interest rates. These include:

  • Qualified Personal Residence Trusts (QPRTs) which benefit from bigger discounts on the value of a gifted property; and,
  • Charitable Remainder Trusts (CRTs) which benefit from bigger discounts on the value of the future income you receive from the trust.

In both cases, higher interest rates make the value of future interests less valuable today, making the strategies more valuable.

Qualified Personal Residence Trusts (QPRTs)

A Qualified Personal Residence Trust (QPRT) can reduce your estate taxes by transferring a residence out of your estate at a discount. This can be a primary or secondary residence, but not an investment property. The property is transferred into an irrevocable trust for a certain period of years, which becomes the term of the trust. At the end of the term, the residence is transferred to the trust’s beneficiaries (or another trust) and is no longer within the original owner’s estate.

There are two main factors to consider when establishing the trust. The goal is to minimize the reportable value of the gift for estate tax purposes.

  1. Interest rates – The transfer is considered a gift in the current year. The gift’s value is discounted based on current interest rates, which reduces the size of the gift. When interest rates are higher, the amount of discount is increased.
  2. Length of the trust term – If the trust’s term is longer, the gift value will be decreased. The grantor is deemed to have derived more value from the property during the trust’s term, thus reducing the gifted amount.

We still haven’t addressed the elephant in the room: Am I really going to give away my own house? It is important to understand that at the end of the QPRT term, the grantor will no longer own the home. However, you are still allowed to live in the home and even have the benefit of paying rent to your new landlords (yes, benefit!). Paying rent is a benefit because it permits you to make additional tax-free gifts, in the form of fair-market value rent payments, to your beneficiaries. These rent payments are not required to be reported as income and help transfer even more assets outside of your estate. From an estate tax perspective, the ongoing rent payments are often considered just as valuable as the initial home transfer itself! Plus, all appreciation of the house from the time the QPRT is established is also excluded from the donor’s estate.

Charitable Remainder Trusts (CRTs)

A Charitable Remainder Trust (CRT) is a powerful tool for clients who are charitably inclined but would like to receive an income stream from their assets for a period or time. A CRT creates a ‘split interest’ between an individual and a charity – the grantor receives an income stream, and the charity receives what’s left over at the end of the term or the trust. Like most charitable gifts, it often makes sense to fund a CRT with low-basis stock.

You will receive a current year tax deduction based on the calculated value of the remainder interest intended for charity. When interest rates are higher, the calculated value of the annual payments is reduced. This increases the value of the remainder interest, which increases the current year tax deduction.

You have many choices when establishing the CRT, such as the length of the trust and the payment amount. Most notably, you can either establish a Charitable Remainder Annuity Trust (CRAT) or a Charitable Remainder Unitrust (CRUT). These both pay a fixed percentage of the trust each year. Payments from the CRAT are based on the trust’s initial value and never change, while CRUT payments are adjusted each year depending on the value of the trust.

Other Financial Considerations

Below are a few additional topics to consider in the current interest rate environment, beyond the world of estate planning:

  • Understand your debt – Certain debt may have been reasonably attractive in recent years, such as home equity lines of credit or margin loans. These are typically tied to interest rates and may have increased considerably in recent years.
  • Understand your cash – Cash yields have increased considerably in recent years, with many cash and equivalents now yielding 5%+. Review your current checking and savings accounts to ensure you are receiving sufficient yield. Additionally, understand the potential impact of declining rates. Falling interest rates may make cash less attractive and make other parts of the portfolio more attractive.
  • Consider home purchases – For years, we assumed mortgages could be obtained at historically low rates with attractive monthly payments. Mortgage rates are considerably higher now. It may be worth discussing alternative financing, such as becoming a cash buyer.

In summary, whether you are optimizing your portfolio, reconsidering your banking relationships, or implementing advanced estate planning techniques, the current level of interest rates is an important consideration. Feel free to contact your JMG financial advisor if you have any questions on the appropriateness of various estate planning techniques. We invite you to share this article with others who may also find it insightful.

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