For many people, passing on wealth to future generations is a top priority. There are many ways to do this through proper estate planning, and one of those strategies is to create a grantor-retained annuity trust or GRAT.
Let’s look at what a GRAT is, how it works, and help you determine whether it suits your financial situation.
What is a Grantor Retained Annuity Trust?
According to Fidelity, a GRAT is “a trust created so that individuals and families can move wealth to heirs while using little, if any, of their lifetime federal gift and estate tax exclusion.” According to the IRS, the basic exclusion amount in 2023 is $12,920,000. This means that a grantor can gift his or her heirs up to this amount tax-free under the gift exclusion. However, individuals with a high net worth and significant assets may still search for tax strategies to gift more assets to their heirs. This circles back to a GRAT.1,2
To set up a GRAT, the grantor sets up an irrevocable trust for a certain timeframe, assets are placed in that trust, and an annuity is paid out to the grantor every year. When the trust expires, the beneficiary receives the remaining assets and pays little to no gift taxes.
According to Investopedia, when creating a GRAT, the grantor puts the assets in a trust but still receives the original value of the assets while earning a rate of return established by the IRS. This rate called the 7520 rate, is used to value certain charitable interests in trusts. As of March 2023, it’s 4.40%.3,4
What Assets Can You Put in a GRAT?
You can put virtually any type of asset in a GRAT, but the most efficient way to use a GRAT is to place assets in it that you think will increase in value over the annuity term. This might be real estate or stock in a pre-IPO or IPO company, which you think will increase substantially. This is because only the appreciation transfers to the beneficiary at the end of the term.
Let’s look at an example. You put $1 million of stock in a GRAT and set the term length for four years. You then get a $250,000 annuity payment per year (4 x $250k = $1 million) plus interest (that 7520 rate mentioned earlier). Then, at the end of the term, your beneficiary receives the appreciation of that asset over the 4 years of the term. Because it’s only appreciation, the IRS doesn’t consider it a gift and is exempt from gift tax.
The Benefits of GRATs
The main benefit of GRATs is that you can pass along more wealth to your heirs and avoid paying a gift tax, which can be up to 40%. This benefit is why so many wealthy individuals choose to create GRATs. ProPublica says that more than half of the 100 wealthiest families in America have used GRATs to avoid estate and gift taxes.5,6
GRATs are especially beneficial in a low-interest market.
Considerations of GRATs
As with any financial decision, there are considerations when setting up a GRAT. The first is that rising interest rates and market valuations could reduce the effectiveness of a GRAT. Also, potential tax legislation changes could alter the benefits and structure of a GRAT.
Is a GRAT Right for You?
Depending on your situation, a GRAT could be a good option for you to pass down wealth to your heirs tax-free. Talk to your estate planning attorney or trusted financial advisor to see if it makes sense for your overall plan.
Spectrum Wealth Counsel, doing business as Spectrum Wealth Management, LLC, is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Additional information about Spectrum’s investment advisory services is found in Form ADV Part 2, which is available upon request. The information presented is for educational and illustrative purposes only and does not constitute tax, legal, or investment advice. Tax and legal counsel should be engaged before taking any action. The opinions expressed and material provided are for general information and should not be considered a solicitation for purchasing or selling any security.