For wealthy individuals, estate planning can be one of the most taxing (pun intended) and frustrating parts of creating a comprehensive financial plan. You worked hard to accumulate your wealth, and you want to pass as much of it as possible along to your heirs and beneficiaries. But because of the size of your estate, you’re on the hook to pay quite a bit in estate and gift taxes.
Luckily, there are a few maneuvers you can make that can greatly reduce the amount you owe in taxes. And one of them is creating a grantor-retained annuity trust (GRAT).
What Is an Annuity Trust?
For starters, let’s discuss annuities, since they’re such a large component of GRATs. An annuity is a financial mechanism wherein you contribute funds or assets (like shares of stock or options) into an account, and then that account distributes money back in equal installments to you on a regular basis—either immediately or at some point in the future.
Therefore, in its simplest terms, an annuity trust enables you to contribute funds or assets into a trust, and then that trust distributes an annuity to a beneficiary on a regular basis. With a grantor-retained annuity trust, the person setting up the trust is the grantor, so when you retain the annuities from the trust, those payments distribute back to you.
How Does a GRAT Work?
Beyond simply paying out annuities, GRATs are really used for their ability to minimize your tax liability. For estate planning purposes, a GRAT is a type of gifting trust that allows individuals to transfer high-yielding and/or rapidly appreciating property or assets (again, typically shares of stock) to a beneficiary with minimal gift or estate tax. The trust also pays out an annuity to the grantor every year, which can work as part of your retirement income strategy.
The grantor sets up the irrevocable trust, including the term of the trust (e.g. 2 years, 5 years, 10 years, 20 years, etc.), and contributes funds or assets into the account as a lump sum. Every year, the grantor is then paid out a fixed annuity, usually a set percentage of the original amount in the trust. For example, if you set up a GRAT with $100,000 and a fixed annuity of 6%, you would receive $6,000 every year, regardless of how much is left in the trust in subsequent years. The exception is if the value of the trust drops below the annuity payment amount. In that case, the annuity payment will be what is left of the trust assets, and no further payment will be made from the trust. Unlike an annuity offered by an insurance company, if the trust runs out of money, no further annuity payments are made.
Finally, at the end of the trust’s term, any remaining funds, including any appreciation on the assets, is transferred to the beneficiaries.
How Are GRATs Taxed?
GRATs are taxed in two ways: Any income you earn from the appreciation of your assets in the trust is subject to regular income tax, and any remaining funds/assets that transfer to a beneficiary are subject to gift taxes.
However, there’s a nuance to the rules of how you determine what’s owed in gift taxes that could enable you to avoid them altogether.
The gift tax is determined at the time the GRAT is created by subtracting the grantor’s retained interest in the trust (i.e. the totality of the annuity payments) from the fair market value of the assets gifted to the trust. The IRS then assumes that the trust-owned assets will generate a return equal to 120% of the Applicable Federal Annual Midterm Rate (called the “§7520 rate” from Section 7520 of the Internal Revenue Code) for the month that the assets are transferred to the trust. Any appreciation in excess of the §7520 rate then passes to the beneficiaries gift-tax-free.
Since the gift tax amount is determined when the trust is created, the value of the annuity interest ends up being a theoretical or projected figure. So, if you set your annuity to pay out the entirety of the principal value over the term of the trust, plus the assumed appreciation according to the §7520 rate, you effectively “zero out” the trust remainder, meaning you would owe nothing in gift taxes.
Because GRATs are typically populated with high-yield assets, over the trust’s term, it’s expected (or at least hoped) that those assets will appreciate significantly in value to something greater than the value of the projected growth rate, based on the federal tables. Essentially, when you set up your annuity payment schedule, your goal is to get the entire original trust value paid back to you in an annuity, leaving the appreciation to transfer to your beneficiaries without incurring any gift tax.
Figure 1. GRAT Example
|Annuity Interest Rate (§7520 Rate)||0.40%|
|Rate of Return||6.00%|
|Annual GRAT Payment||$1,012,023|
|Total of Payments Received Over Term||$5,060,115|
|Amount Owed in Gift Taxes||$0|
|Remainder Passing to Beneficiaries||$995,348|
|Estate Tax Savings at 40%||$398,139|
In Figure 1 above, the grantor was able to avoid paying gift taxes altogether while also leaving nearly $1 million for their beneficiaries. Meanwhile, if that same dollar amount had passed down to their heirs at their time of death, that gift would be subject to the current 40% federal estate tax, meaning their beneficiaries would have only received $597,209. Thus, by utilizing a GRAT, this person was able to save nearly $400,000 in taxes.
Pros and Cons of a GRAT
There are a number of benefits to setting up a GRAT. For one, the annuities can provide a steady stream of income for those who may need it in retirement.
However, the main benefit of establishing a GRAT is the potential to transfer large amounts of money to a beneficiary while paying little-to-no gift tax. Gifting is an important part of estate planning, since it allows you to transfer assets to a beneficiary without incurring any tax—as long as that gift does not exceed the federal gift tax exemption. In 2020, the exemption is $15,000, which means that an individual can make gifts up to $15,000 per year without having to pay gift taxes. However, gifts that exceed $15,000 are subject to gift taxes.
By utilizing a GRAT as part of your estate planning strategy, it’s possible to transfer much more than $15,000 to a beneficiary and still not have to pay any gift taxes. Again, this is a huge benefit for wealthier individuals with large estates. It allows them to transfer more valuable assets or properties in a shorter amount of time and avoid or significantly reduce the gift and estate tax liability that such a sizable transfer would typically incur.
There are also some cons to utilizing a GRAT. When a GRAT is created, you also set the term, or lifetime, of the trust. Once the term expires, the remaining assets transfer to your beneficiaries. However, if you pass away before the term expires, then all assets in the trust revert back to you and are included in your taxable estate.
That’s why setting the term can be a bit of a risk. Longer terms allow more time for your assets to appreciate, and yielding a high capital gain is the main driver behind establishing a GRAT in the first place. However, the longer you set the term—for example, 20 years—the greater the chance that your health could seriously decline as you age, and the greater the risk that you don’t live to see the end of the term.
Additionally, since you’re typically only avoiding gift tax on asset appreciation, it makes sense to only populate your GRATs with high-yielding assets like shares of stock. If you’re not seeing significant appreciation with these assets, it might not be worth it to establish this type of trust. When you factor in the money and effort required for drafting a GRAT, the juice just might not be worth the squeeze, and you could get away with gifting these funds or assets through more traditional means.
Lastly, gifted assets retain the cost basis you hold in the assets. This means that when your beneficiaries eventually sell the asset, they will have to pay capital gains taxes on the full gain associated with the property—not just the gain they realized from the time they received the asset. Your beneficiaries may therefore end up having to pay significant income taxes on the gifted property.
That being said, the capital gains tax (a maximum of 23.8%) will still likely be lower than the estate tax you would owe (currently 40%). Moreover, if your beneficiaries are in a lower tax bracket than you, you may also be able to save in total income taxes.
Adding a GRAT to Your Estate Plan
GRATs can be a valuable part of your estate planning process, as they can ultimately leave more of your assets with your family and beneficiaries. Whether or not you should explore this option is up to you. Again, this is a tool typically used by wealthier individuals who have very large estates and highly appreciating assets to transfer to their beneficiaries without being subject to what would otherwise be significant estate and gift taxes.
To learn more about how a grantor-retained annuity trust is taxed and how it may be beneficial to add to your estate plan, reach out to your financial advisor today.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
JD, CFP®, Series 7 Securities Registration,1 Series 66 Advisory Registration,† Life and Health Insurance License Kate has been a financial planner at Wealth Enhancement Group since 2007. Previously, she assisted in the management of trusts and portfolios for high-net-worth clients. She is involved with the Roundtable™ and provides her expertise to help walk clients through the best way to organize their estates to ensure their assets are passed in the most...Read More