A Grantor Retained Annuity Trust (GRAT) is an estate planning tool that allows you to transfer assets to your beneficiaries while minimizing gift and estate taxes. It works by transferring assets into the GRAT, retaining an annuity interest, and structuring the payouts so that any growth above the IRS assumed interest rate passes to beneficiaries tax-free.
How It Works:
- You transfer assets into the GRAT and retain an annuity interest. This means you will receive fixed annuity payments back from the trust over a set term (usually 2-3 years).
- The annuity payments are structured so that by the end of the term, you will have received back all of the assets you originally contributed, plus interest calculated at the IRS 7520 rate (currently around 3%).
- Any growth in the assets above the 7520 rate passes to your beneficiaries gift tax-free at the end of the term. This is the key benefit - assets can grow tax-free outside of your estate.
- The assets you transfer into the GRAT should be those expected to substantially appreciate over the term. This increases the likelihood of beating the 7520 rate and maximizing tax-free transfers.
- GRATs are especially effective when interest rates are low, because it's easier for your assets to outperform the 7520 rate.
Key Strategies to Maximize Benefits:
- Set short 2-3 year terms to reduce mortality and under-performance risk. If you pass away before the end of the term, the assets go back into your estate. Shorter terms reduce this risk.
- Structure annuity payments to increase each year ("backload"). This leaves more assets in the trust longer to potentially grow rather than distributing back to you early.
- "Zero-out" the GRAT by making the annuity payments equal to the initial contribution plus assumed interest. This minimizes gift taxes since the present value of the gift is technically $0.
- Roll distributions from maturing GRATs into new GRATs to perpetually move assets out of your estate. As each GRAT ends, use the annuity payment to fund a new one.
John sets up a 2-year zeroed-out GRAT, funding it with $1 million in stock he expects to substantially appreciate. The 7520 rate is 3%.
In the first year, the GRAT pays John an annuity of $510,000. The stock grows to $1.2 million.
In the second year, the GRAT pays the remaining $510,000 to John.
The remaining $180,000 passes to John's beneficiaries tax-free since it exceeded the 3% 7520 rate.
If the stock had instead grown only to $1.1 million, John would have just received his full $1 million back with no tax-free transfer. There is little downside risk.
Over time, John can roll multiple GRATs and gradually transfer significant appreciation out of his estate gift tax-free if he continues to beat the 7520 rates.
In summary, GRATs allow you to efficiently transfer appreciation out of your estate at little to no gift tax cost if set up correctly. The key is for the assets to outperform the IRS's assumed interest rate. Speak to an estate planning attorney for specifics on your situation.
The GRAT is very technical and takes steps to deploy properly but often times for families with wealth above the estate tax lifetime exclusions it is a handy tool and well worth the time and expense to put in place.