No pain, no gain. You already may feel the pain of falling interest rates as the yield on your savings dwindles down toward zero. But there is gain to be had, too.
In the arcane netherworld of estate planning, thicketed with acronyms like SCINs, GRATs and IDGTs, and under the peculiar rules of the Internal Revenue Service, low interest rates enable you to transfer more wealth to your heirs tax-free. On top of that, you can buy an unusual bond specifically designed to protect your heirs from losing money if rates rise.
So, with yields near lows, now is the time to stop moaning about the lack of income and to start turning rock-bottom interest rates to your advantage.
If your children are about to borrow money and you think they are a good credit risk, you might wish to be their banker yourself.
For October, under the rates set monthly by the IRS, you can make a nine-year fixed-rate loan to Junior for as low as 2.63%. That low-hurdle rate enables your child to borrow dirt-cheap. Better yet, you and your spouse could forgive up to $52,000 of the loan annually ($26,000 if your child is single), reducing your future estate tax liability without triggering current gift taxes.
Be sure to draft an agreement stipulating the principal amount and term of the loan as well as whether interest payments are due annually, semiannually, quarterly or monthly. State that unpaid interest will accrue to principal. And plan on collecting interest for at least a year before forgiving any of the loan. Otherwise, the IRS may accuse you of planning it as a gift all along.
At www.irs.gov, search for "applicable federal rates," then click on the first hit. Next, select the AFR from Table 1 that corresponds to the length of the loan: short term (three years or less), midterm (between three and nine years) or long term (longer than nine years). That is the rate you should charge.
Your child is free to refinance at any time with the Bank of Mom & Dad. If the IRS rate drops again, simply draft a new agreement setting the interest on the loan at the lower rate. However, warns John Evans, a financial adviser at Truepoint Capital in Cincinnati, lengthening or shortening the term of the loan may get you into trouble with the IRS.
Several more-complex techniques exploit the falling hurdle of IRS interest rates. Because these tactics are costly to set up and are designed to minimize federal estate taxes, they generally make sense only if you have several million dollars in wealth. Don't try them at home; they demand the expertise of a trust attorney or a financial adviser who specializes in estate planning.
With a SCIN, or self-canceling installment note, you sell an asset to a family member. To finance the sale, you provide a fixed-rate loan to the buyer, stipulating that any unpaid balance will be canceled when you die.
A GRAT, or grantor-retained annuity trust, may enable you to transfer future appreciation on an asset to your heirs. If you outlive the term of the trust, most commonly two or three years, then a portion of the gain on the assets will move to your heirs free of gift or estate tax. If you die before the term of the trust expires, however, the assets revert to your estate and are taxable.
An intentionally defective grantor trust, or IDGT, is perfectly legal and isn't actually defective. It involves making a partial gift to a trust, which then purchases the rest of the asset in installments. IDGTs (sometimes pronounced "idjits") are often smarter than GRATs, because IDGTs move an asset out of your estate immediately.
Middle-class investors who hold a substantial balance in bonds might consider protecting heirs. Corporate notes, offered directly to individuals in denominations as low as $1,000, carry an unusual feature called a "survivor's option" or "estate put."
If you mature before these notes do, that is, if you die before they come due, your heirs have the right to cash out at 100 cents on the dollar. That could be key if rates rise, which normally pushes down bond values. Such notes are issued by Bank of America, Freddie Mac, General Electric Capital and HSBC Finance; see www.internotes.com. Check that the note is noncallable.
Stephen Horan, head of private-wealth services at the CFA Institute, points out that the older you are, the more valuable the "estate put" becomes, to your heirs who will live after you. With rates so low today, the potential upside for the estates of older investors is higher than ever.