Grantor retained annuity trusts (GRATs) have become popular estate planning tools for wealthy families. Implemented properly, a GRAT can provide guaranteed income for the grantor and pass on wealth tax free to beneficiaries. In this article, we’ll look at how GRATs are structured, how they can help families avoid gift and estate taxes, and the potential drawbacks of establishing a GRAT.
What is a GRAT?
A GRAT is an irrevocable trust that allows individuals to contribute appreciable assets and receive a stream of annuity income during the life of the trust. Annuity payments are made for a specified period, often between two and ten years. At the end of the annuity period, any remaining assets are distributed to the trust’s named beneficiaries.
- The grantor of a GRAT is the person who makes the initial contribution.
- The beneficiary of a GRAT is the person (or people, often the grantor’s children) named to receive the balance of the trust after the annuity payments have been distributed to the grantor.
- The trustee is the person charged with managing and distributing the assets in the trust. This can be the grantor or another person the grantor designates for this role.
How do GRATs limit gift and estate taxes?
A GRAT begins when the grantor makes a gift to the the trust. To determine the value of this gift, the IRS considers the amount of the initial contribution, the amount the grantor is scheduled to receive from the annuity, and an expected rate of return on the contributed assets, which is set by the IRS and listed as the Section 7520 interest rate. Gains that exceed this rate can be passed to beneficiaries free of gift or estate tax.
The greater the annuity interest retained by the grantor, the lower the amount that will be subject to gift tax. In what has become known as a “Walton GRAT,” grantors designate an income stream that is calculated to reduce the value of the gift portion of the GRAT to zero. In this way, beneficiaries can receive all remaining funds free of gift or estate tax.
While there is no guarantee that assets will perform at or above the Section 7520 rate, funding a GRAT with assets that have the potential to significantly increase in value (like pre-IPO stock) can result in dramatic tax savings. In the event the assets fail to generate sufficient income to cover the annuity payments, these payments will be made using the trust’s principal. There may be nothing left in the trust to pass on to beneficiaries, but there is no tax penalty for underperforming GRATs.
How do gift and estate taxes work?
Most families will never owe gift or estate taxes. That’s because high thresholds must be met before these taxes apply. In 2023, gifts of less than $17,000 per recipient per year are not reportable to the IRS, and the Unified Tax Credit, a combined exemption limit for gift and estate transfers, allows individuals to transfer a combined amount of up to $12.92 million (or $25.84 million for a married couple) without incurring gift or estate taxes. That means even if you give a gift that exceeds the $17,000 gift tax exemption, you won’t necessarily have to pay taxes on it, though you will have to file a gift tax return; instead, it could simply be counted against the Unified Tax Credit. The Tax Cuts and Jobs Act of 2017 (TCJA) created a significant bump in this combined exemption, which had previously been set at $5 million. This increase, however, is set to expire in 2025.
What should I consider when setting up a GRAT?
A GRAT has the potential to create substantial tax savings, but proper planning is essential. If you’re considering contributing appreciable assets like shares of your company stock to a GRAT, be sure to get the help of experienced professionals, understand your tax obligations, and be aware of potential drawbacks.
Work with trusted legal and investment professionals.
If you’re considering setting up a GRAT, it’s critical to work with an experienced estate planning attorney to ensure it’s properly structured. GRATs must be set up for at least two years, but they may last much longer. Consult with a trusted investment advisor to determine the ideal term for your GRAT in the current economic climate.
Be aware of performance hurdles.
To successfully pass money free of gift and estate tax to beneficiaries, a GRAT needs to outperform the 7520 rate, also known as the “hurdle” rate. One strategy advisors have promoted to cope with recent interest rate increases is setting up a series of two-year rolling GRATs. The first year’s annuity payment from the original GRAT is used to set up another two-year GRAT, which is subject to a new hurdle rate at the time it’s created. In this way, investors can avoid being locked into a high hurdle rate over the long term.
Consider your life expectancy.
To pass remaining assets on to beneficiaries, the grantor of a GRAT must survive its term. If the grantor dies before the term is completed, the assets pass to the grantor’s estate rather than to the beneficiaries. As a result, the potential tax benefit may be lost. If you set up a GRAT when interest rates are low, it can be tempting to lock in the low hurdle rate for several years; however, the potential benefit of this must be balanced with the risk that the GRAT would outlive you.
Be prepared to pay taxes on the trust’s earnings.
As the grantor of a GRAT, you are responsible for paying taxes on its earnings. GRAT earnings are subject to regular income tax, and the grantor’s tax liability is not dependent on the amount of income received from the annuity. Work with your financial planner to ensure you’re prepared to make required tax payments throughout the life of the GRAT.
Is a GRAT right for you?
High-earning taxpayers have powerful tools at their disposal for minimizing their tax liability. GRATs have the potential to facilitate the tax-free transfer of substantial wealth to your loved ones while providing you a guaranteed stream of income. If you think a GRAT might be an appropriate estate planning tool for you, consult with your trusted financial advisors to discuss the potential benefits and drawbacks and determine the best execution strategy.
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