If one of the more typical annuity options is not the best fit for you, there are also various types of gift annuities that offer different advantages. One such type of gift annuity is called a grantor retained annuity trust. Continue reading to understand more about grantor retained annuity trusts.
What is a Grantor Retained Annuity Trust?
A grantor retained annuity trust (GRAT) is a financial instrument that is commonly used when people are planning to pass down assets such as property or large sums of money to the next generation upon their death. GRATs are an irrevocable trust that allow people to minimize or completely avoid the estate, gift and inheritance taxes incurred on their assets when passing them down to their beneficiaries. When one decides to open a GRAT, they establish their trust and fund it with the cash and assets that they wish to pass down. Then, they are entitled to annuity payouts for a period of time that they determine, which is usually two to five years. Once the annuity period is over, the remaining value of the trust and all of the assets within the trust are passed on to the named beneficiary.
How does a Grantor Retained Annuity Trust Work?
A grantor retained annuity trust is a particular type of trust that consists of two distinct phases. The two phases are the term of years during which the grantor receives annuity payouts (known as the GRAT term), and the period of time after the GRAT term has ended while the assets are still held in trust (called the remainder term). During the GRAT term, the annuity payout amounts are fixed, and the payout rate is based on the IRS rate in effect during the month that the GRAT is created. During the GRAT term, which is a length of time specified by the grantor, the annuity payouts that are made to the grantor are the only distributions made from the GRAT. Once the GRAT term ends, the trust terminates and the property and other assets that remain in the trust may be held in a continuing trust to be passed down to the grantor’s designated beneficiaries.
When a GRAT is created, it is typically structured as a “zeroed-out GRAT”. This means that the grantor contributes assets to the trust but retains the right to receive the original value of the assets in the form of annuity payouts. The original value of the assets will be paid back to the grantor over the course of the term of the GRAT, and the grantor will simultaneously also be earning a rate of return that is specified by the IRS. With a zeroed-out GRAT, since the grantor retains an annuity that is equal to what he or she contributed to the GRAT, the IRS views the transaction as a zero-value gift, and therefore the grantor does not use a portion of his or her exemption from federal gift tax. This allows the assets that remain in the GRAT to be passed to the beneficiaries tax-free.
The best assets to contribute to a GRAT are assets that are expected to rapidly appreciate in value over the term of the GRAT.
In the event that the grantor dies during the GRAT term, then the assets in the GRAT will be transferred back into the grantor’s estate, in which case the benefits that are provided by a GRAT are no longer available. If the grantor dies during the GRAT term, the estate tax will be applied to the assets when they are passed down. It is primarily for this reason that grantors typically create short-term GRATs (such as two or three years), and roll each year’s annuity payment into a new GRAT.
Uses for a GRAT
Grantor retained annuity trusts are most useful to wealthy individuals who will face substantial estate tax liability upon death. In this instance, the individual can use a GRAT to preserve the value of his or her estate for themselves and transferring the appreciation of the assets to his or her heirs. GRATs can be used to perform large transfers of wealth with significant estate tax savings.
Another effective use of a GRAT is in conjunction with transfers of ownership in startup companies. This is because startup companies typically have a lower value initially, and may have a strong growth rate. Placing shares of a startup company into a GRAT will ensure that the full value of the stock appreciation will be retained upon transfer. Stock price appreciation for IPO shares will usually outpace the IRS assumed rate of return, making this a relatively reliable tax-saving strategy.
Advantages of Opening a GRAT
Disadvantages of Owning a GRAT
The Bottom Line
GRATs can be extremely advantageous in particular scenarios when an individual wants to avoid the implications of a large estate tax liability. However, GRATs can be complex financial instruments. It is crucial for individuals to speak with financial advisors when considering if a grantor retained annuity trust is a smart move for them.
Special thanks in preparing this summary of “What is a Grantor Retained Annuity Trust?” goes to Bob Carlson, leader of the Retirement Watch advisory service and chairman of the Board of Trustees of Virginia’s Fairfax County Employees’ Retirement System with more than $4 billion in assets.