Strategies for a Low Interest Rate Environment Next item Basic Estate Documents...

Strategies for a Low Interest Rate Environment

The Federal Reserve plans to keep interest rates low until at least 2023, in this article we offer six financial planning strategies that benefit from a low interest rate environment. Additionally, the Applicable Federal Rates (AFR)*, a series of interest rates that apply to personal loans and wealth transfer mechanisms, are at all-time lows. While low interest rates generate less yield on cash and bonds, they present a number of planning opportunities.

Wealth Transfer

Moving assets outside of your taxable estate during your life will reduce your gross estate and, in turn, the amount of estate tax ultimately due. However, transferring the assets outright while you’re alive may trigger a taxable gift. To minimize this, you can take advantage of current low interest rates to maximize wealth transfer outside of your estate by:

  • Creating a Grantor Retained Annuity Trust (GRAT) to transfer assets that have high appreciation potential.
    • If successful, this trust can help you transfer assets outside of your estate using low or no gift tax exemption. During the trust term (typically 2 years), you receive annuity payments valued at the initial funding plus a predetermined level of return set at the 7520 interest rate (120% of midterm AFR rate). At the end of the term, the remaining assets (which are equal to earnings above the 7520 rate, if any) will transfer outside of your estate to the beneficiary or remainder trust you have directed. This wealth transfer method is more advantageous when AFR rates are low, as it is a lower hurdle rate for appreciation.
  • Creating a Charitable Lead Annuity Trust (CLAT) to transfer assets that have high appreciation potential.
    • This technique is similar to a GRAT, but instead of the annuity payments coming back to you during the trust term, they are paid out to a charity that you’ve named. At the end of the trust term, any appreciation can be transferred outside of your estate to the beneficiary or remainder trust you have directed. Depending on how this trust is structured, you could reduce or avoid estate or gift tax.
  • Optimizing Intra-family loans
    • You can make or refinance existing loans to family members or trusts for the benefit of family members without it being a deemed gift, as long as you abide by the published AFR and corresponding term. If that family member or trust invests the borrowed cash and earns more than the AFR rate, he or she has created additional wealth outside of your estate. 
    • Keeping loans within your family versus applying for conventional financing will also ultimately keep more wealth within your family, as the interest payments will come back to you instead of a bank.

Debt Strategies

Taking on a prudent level of debt in a low interest rate environment can be beneficial. You could take advantage of current low borrowing rates to maximize your earning potential by: 

  • Refinancing existing debt to take advantage of drop in rates and lower interest payments
  • Financing your first and/or second home
    • Using an interest only product (7/1 or 10/1 ARM, for example) will minimize your monthly payments while giving you more cash to invest and hopefully earn more than the interest rate over the term of the loan.
    • If you are taking advantage of a cash-out refinance, your ability to deduct the interest is dependent on what you use the cash for. If used for anything other than capital improvements or purchasing investment assets, the interest will not be deductible (there are some cases where you can deduct as mortgage interest up to a certain cap if it is done within a short time frame from the purchase).
  • Utilizing a margin loan to increase buying power to potentially earn a return on investment that is greater than the borrowing cost. This technique comes with risk, including permanent loss of capital as market factors could create a margin call, requiring possible untimely liquidation of securities.

In this time of uncertainty, it is a great time to review your goals and determine whether there are techniques that can be applied to maximize wealth accumulation and transfer to help meet your long-term objectives.

*Applicable Federal Rate (AFR): The IRS publishes rates monthly for short (up to 3 years), medium (4–9 years), and long (10+ years) terms. Using these rates for personal loans will avoid a challenge from a gift tax standpoint.