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They say only two things are certain: death and taxes. Luckily, smart estate planning can help cover both those bases. Gift tax, estate tax and income tax are among the oft-encountered tolls that a properly planned estate seeks to minimize. In fact, estate tax can eat up as much as 40% of an estate whose worth surpasses the federal tax exemption.
Some wealthy estates turn to a grantor retained annuity trust, or GRAT, to pass assets to a beneficiary—in a way that can significantly reduce tax burdens. A GRAT allows assets to appreciate and pass to heirs, all with little or no estate taxes or gift taxes.
What Is the Purpose of a GRAT?
GRATs are irrevocable trusts (meaning, they rarely can be altered or revoked) structured to protect the trust's beneficiaries from taxes, while guarding the grantor's estate from additional taxes. It freezes part of an estate's value in a trust and passes future asset appreciation to heirs in a way that avoids estate tax.
For example, imagine you have assets worth $15 million that you think will grow to $25 million over the next five years. You'd hope to pass on at least some of this wealth to loved ones when you die. As part of your estate, a portion of those assets would be tax-exempt, according to IRS rules, but any property of the estate that surpasses the exemption would be hit with the "death tax" when passed on to heirs.
GRATs protect that asset appreciation by eliminating the taxes on the money's growth when the money is passed down to heirs. Here are the basics of how a GRAT works:
- The creator of the trust, or grantor, moves their assets into the GRAT for a set period of time, usually five to 15 years. The GRAT is overseen by an appointed trustee (and, sometimes, an extra set of eyes selected to supervise) who manages the trust for a predetermined period.
- The grantor is then paid an annuity (regular income payments) based on a percentage of the fund's assets or those assets' growth and in accordance with the IRS' current Section 7520 interest rates. If desired, the grantor can choose to receive smaller annuity payments initially and increase them by as much as 20% annually—this can result in extra assets left in the trust to appreciate over the GRAT's term.
- Once the GRAT's term ends, the fund's remaining assets go to the beneficiaries, who do not pay tax on the fund's appreciation.
The funds in the trust, technically separate from the grantor's personal estate, aren't subject to estate tax; the annuity payments, as assets "returned" to the grantor, don't face a gift tax. And income taxes don't touch asset growth within the trust, leading to uninhibited growth during the GRAT's term.
Who Pays Taxes on a Grantor Retained Annuity Trust?
Although beneficiaries receive the asset growth, the grantor maintains the tax liability of the trust itself. Income generated by the GRAT is taxable to the grantor, and it's not uncommon for a GRAT to "fail," reverting the trust assets back to the original estate.
For example, the GRAT must bring returns at or above the interest rate dictated by the IRS Section 7520. The trust fails if it doesn't match significant returns in the IRS' eyes. The principal investment then covers the annuity and the GRAT assets return to the grantor's estate. Because of this, it's best to seek a GRAT strategy when the 7520 rates are low.
Similarly, in the case of a grantor's untimely death within the annuity period, the trust's contents return to the original estate and face the accompanying tax; the originally intended beneficiaries would no longer receive the assets.
To avoid the potential tax liability pitfalls of a failed GRAT, several strategies exist. Grantors may elect to employ a zeroed-out GRAT, or Walton GRAT, matching the total annuity payments to the original value of the GRAT. This way, the beneficiaries of the trust can enjoy all the tax-free asset appreciation while the benefactor reduces the value of their taxable estate.
Another popular option is to use rolling GRATs, which benefit from short annuity terms, often just a couple years long. The annuity payments of the original GRAT are cycled back into a new GRAT, starting the process over and keeping the assets continuously protected.
How Much Does It Cost to Set Up a GRAT?
Your designated trustee is entitled to "reasonable compensation," usually as an annual 1% to 2% of the trust. However, that's not the only cost you face for a GRAT.
To create and succeed with a GRAT, you need professional assistance. And, naturally, the pros who handle trust funds and wealthy estate planning don't exactly come cheap. Whereas drafting a simple will costs a few hundred dollars; a complex estate plan involving a trust, like a GRAT, costs several thousand dollars. Because they are such a complex estate planning strategy, GRAT grantors should seek qualified help from a financial planner and attorney. You can check the Financial Regulatory Authority's database of finance professionals (which you can also use to verify a pro's credentials).
The Bottom Line
Even for estates with less than Mark Zuckerburg-level assets, low interest rates from the IRS and pandemic-slumped asset values can make for an ideal GRAT environment. When handled wisely, generations can be set for success with a GRAT as part of the plan.