You work hard to accumulate wealth, and you want to pass as much of it as possible along to your heirs and beneficiaries. But due to the size of your estate, you're on the hook to pay a hefty sum in estate and gift taxes.

It's a story we see every day. Fortunately, we can use smart estate planning strategies to reduce estate taxes. A particularly effective strategy involves the creation of a grantor-retained annuity trust (GRAT), which is just one of the many types of trusts that provide tax benefits.

A GRAT is an estate planning tool that allows you to move assets out of your estate, receive income from those assets, and potentially avoid gift taxes on the leftover amount you transfer to your beneficiaries.

What Is a Grantor Retained Annuity Trust?

First, let's cover the constituent parts of a GRAT. An annuity is a financial instrument wherein you contribute funds or assets (such as stock or options) into an account, and then that account distributes money in equal installments regularly. An annuity trust is simply a trust designed to distribute funds like an annuity. In other words, you contribute assets to a trust that issues regular disbursements.

With a grantor-retained annuity trust, the person setting up the trust is both the grantor and the grantee. Unlike other commonly used types of trusts, GRATs pay the proceeds back to the person who funded them.

How Does a GRAT Work?

GRATs are typically used by individuals who have large estates when they want to transfer appreciating assets to beneficiaries without being subject to significant taxes.

Let's begin with a basic example of a GRAT, ignoring the tax part for now.

First, the grantor sets up an irrevocable trust. They set how long the trust will last before it expires (the term), specify the percentage of the trust to be paid out each year (the annuity), then fund the trust with assets. Every year, the grantor will receive the annuity.

When the term expires, the remaining funds will pass to the beneficiaries.

To illustrate, let's say you have $1,000,000 worth of stock that you want to pass to your beneficiaries but still benefit from over the next decade. In this case, you can set up a GRAT, fund the trust with your stock, set the term as 10 years, and specify that you want to receive 6% of the original trust amount as your annual annuity. Each year, you'll receive $60,000 from the trust. After the 10 years are up, any remaining value passes to your named beneficiary.

You may be wondering, "So what?" The "So what" comes from the unique tax treatment of GRATs—which reveals their true power.

How Are GRATs Taxed?

GRATs are taxed in two ways.

First, any income you earn from the appreciation of the assets in the trust is subject to regular income tax. Second, any remaining funds that transfer to your named beneficiary after the GRAT expires are subject to gift taxes.

However, there's one big asterisk to this second type of taxation: what you could owe in gift tax is calculated at the time you create the GRAT—not when the trust assets pass to your beneficiaries. And GRATs provide a way to potentially circumvent this gift tax entirely.

When you load assets into the trust, the IRS predicts how much those assets will grow. The IRS assumes the trust-owned assets will generate a return equal to 120% of the Applicable Federal Annual Midterm Rate for the month that the assets are transferred to the trust. This rate is called the Ҥ7520 rate", from Section 7520 of the Internal Revenue Code, and is also known colloquially as the "hurdle rate".

Any appreciation of the trust assets more than the hurdle rate then passes to the beneficiary’s gift tax-free.

Thus, to entirely avoid the gift tax, savvy GRAT creators set the term and annuity rate such that the entirety of the IRS's predicted return will be paid out to the grantor over its lifetime. Doing so effectively "zeroes out" the trust remainder, meaning you'll owe nothing in gift taxes on the amount you transfer at expiry.

Because of this, GRATs are often populated with high-yield assets with the hope that those assets will appreciate to a value significantly greater than the hurdle rate.

When you set up your annuity payment schedule, your goal is to get the IRS's projected return paid back to you through the annuity, leaving the extra appreciation to transfer to your beneficiaries without incurring any gift tax.

Next, let's look at a fully-fledged GRAT example.

GRAT Example with Explanations

In this example, the grantor established a GRAT with a 10-year term. They loaded $1,000,000 worth of assets into the trust and assumed that those assets would grow 8% per year.

Figure 1. Detailed GRAT Example

In this example, we used the July 2023 hurdle rate of 4.6%. This allowed us to calculate what the annuity payments needed to be to "zero out" the trust. In this case, the grantor needs to receive 10 annual payments of $127,000 each from the GRAT, totaling nearly $1.3 million over the trust's term.

We assumed the grantor loaded the GRAT with assets that would grow 8% per year—higher than the IRS's hurdle rate. After the grantor receives the annuity payments and the GRAT expires, the beneficiary of the trust will receive a total of $319,127. Because this remainder is above the IRS's predicted return, there would be no gift tax on this total.

Assuming the current 40% federal estate tax, this strategy saves $127,651 in estate taxes compared to if that value had been transferred without a GRAT.

Grantor Retained Annuity Trust Pros and Cons

Pros of a GRAT

First and foremost, the annuity from a GRAT can provide a steady stream of income for a grantor who may need it in retirement. However, the main reason people use GRATs is not for the annuity itself but for the potential to transfer substantial amounts of money to a beneficiary while paying little estate tax.

Gifting is an important part of estate planning, but the federal government limits how much everyone can donate each year. In 2023, the federal exemption is $17,000 per person—you can only give $17,000 to each individual before the gifted amount starts counting against your lifetime gift tax exclusion ($12.92 million in 2023).

GRATs allow you to bypass this amount considerably. In the above example, the grantor gifted over $300,000 to their beneficiary without triggering gift tax.

Cons of a GRAT

GRATs are not without their risks.

The first risk relates to the term. When a GRAT is created, you set the term of the trust. If you pass away before the term expires, all the assets in the trust revert to you and are included in your taxable estate. This can result in a hefty tax bill for whoever inherits those assets.

Longer terms allow more time for your assets to appreciate, which is important because yielding a higher capital gain is the main driver behind establishing a GRAT. However, the longer you set the term, the greater the chance you don't live to see the end of it.

The second con is if the assets in the GRAT depreciate instead of appreciating. In this case, your annual annuity payments could "drain" the entire principle of the trust, and there will be nothing left at the end of the term. This won't result in an adverse outcome—the trust will simply stop paying when it runs out of money—but your beneficiaries won't be left with anything after the trust expires.

Additionally, since you're typically only avoiding the gift tax on asset appreciation, it only makes sense to populate your GRAT with high-yielding assets. If you're not expecting to see a significant appreciation of the assets, establishing a GRAT may not be worth the effort. When you factor in the money required to draft and maintain a GRAT, the juice just might not be worth the squeeze.

Finally, assets gifted through a GRAT don't experience a "step-up in basis." Instead, your beneficiaries retain the cost basis you initially held in the assets. This means that when your beneficiaries eventually sell the assets, they received through the GRAT, they will need 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.

That said, the capital gains tax is a maximum of 23.8%, assuming the maximum income threshold and the Net Investment Income Tax (NIIT). This doesn't seem too bad when compared to the estate tax your beneficiaries would've owed if they received the assets outright (up to 40% in 2023).

Adding a GRAT to Your Estate Plan

GRATs can be a valuable part of your estate plan. When used correctly and under the right market conditions, they can help you leave more of your assets with your beneficiaries instead of the government. To learn more about how a GRAT could fit into your estate plan, reach out to your financial advisor today.

This information is not intended to provide tax or legal advice. Discuss your specific situation with a qualified tax or legal professional.