Passing money down from generation to generation inevitably involves taxes. There’s the gift tax and the federal estate tax. Many states also charge an estate tax. However, there is a way to gift larger sums of money without as big of a tax burden: a grantor retained annuity trust (GRAT). A GRAT is a type of irrevocable trust that allows you to minimize the tax cost of passing on assets.
There are specific parameters around how GRATs work and who they are right for. If you’re thinking of using one, you may want to get the help of a financial advisor. SmartAsset can help you find one who is a good fit for you with our free financial advisor matching service.
Grantor Retained Annuity Trust Defined
Grantor retained annuity trusts are a type of irrevocable trust. They potentially allow you to pay little to no estate or gift tax when passing large amounts of money from one generation to the next.
Here’s how it works:
- The grantor establishes the trust and funds it with cash, securities or any other assets they want to pass on to beneficiaries.
- The grantor receives annuity payouts for a period they determine, usually two to five years. The total value of all annuity payments is more than or equal to the initial value, plus interest based on the 7520 rate. This an interest rate determined monthly by the Internal Revenue Service (IRS).
- The annuity period ends. The remaining value of the trust gets passed on to a named beneficiary. This generally is a family member, such as a child or grandchild.
This means that, in theory, the grantor will simply receive all of their money back. Essentially, GRAT creators are counting on the value of the assets they place in the trust appreciating more than predicted based on the 7520 rate the month they create the trust. That leftover money at the end of the annuity period — that is, any value above the total value of the initial assets plus interest at the defined 7520 rate — goes to the beneficiaries. That amount is not subject to the gift tax.
If the trust creator dies before all annuity payments are made, then the trust is considered part of the estate. It is then subject to estate taxes.
Let’s say you create a GRAT and seed it with $5 million worth of stock. That month’s 7520 rate predicts that in three years those assets will be worth $5.5 million. You can set up annuities to pay you exactly $5.5 million in stock converted to cash over three years. The stock value may go up more than that, though. Let’s say $500,000 in stock remains in the trust after your annuity payments end. Your beneficiaries will then receive that stock without paying taxes on it.
If you die, however, the annuity payments stop. Any money that’s left in the trust is subject to estate tax.
Who Should Use Grantor Retained Annuity Trusts?
Grantor retained annuity trusts aren’t for everyone. Setting one up will likely be a good choice mostly for very wealthy families who have a large pool of assets that they want to pass from one generation to the next without dealing with the gift or estate tax.
If you live in one of the 12 states (and the District of Columbia) that has an estate tax, this is more likely to be relevant to you. In many cases, the threshold for the state-level estate tax is lower than the $11.2 million threshold for the federal estate tax. The following states have an estate tax:
- Connecticut ($2.6 million threshold)
- District of Columbia ($11.2 million threshold)
- Hawaii ($11.2 million threshold)
- Illinois ($4 million threshold)
- Maine ($5.6 million threshold)
- Maryland ($4 million threshold)
- Massachusetts ($1 million threshold)
- Minnesota ($2.4 million threshold)
- New York ($5.25 million threshold)
- Oregon ($1 million threshold)
- Rhode Island ($1.538 million threshold)
- Washington ($2.193 million threshold)
Cons of Using a GRAT
There are, of course, some potential negatives to using a GRAT. The biggest risk when you set up a GRAT is that the assets in the trust won’t appreciate as much as anticipated. If the assets appreciate at a rate lower than the 7520 rate, all of the money in the GRAT will end up going back to the grantor, without any excess to go to beneficiaries. The grantor will also have lost all of the legal and administrative fees paid to set up the GRAT.
The second risk is that the person who sets up the GRAT could die during the term of the trust. Since GRATs are generally used by older people to pass on their estate, this is always a risk. If a person were to die before all annuity payments were made, the money inside the trust would become part of the taxable estate. Again, the grantor would be out the legal and administrative fees paid to set up the trust.
The Bottom Line
A grantor retained annuity trust is useful for passing money between generations while potentially avoiding or minimizing the gift or estate tax. It is essentially an annuity in which you bet that the value of the trust at the end of the annuity period will exceed a predetermined amount. You can then pass on that excess amount. Families with a lot of wealth, particularly those in states that have an estate tax, may find GRATs especially useful.
Estate Planning Tips
- To set up a GRAT or do any other estate planning, it may be a good idea to work with a financial advisor. SmartAsset can help you find one with our free financial advisor matching service. You answer a few questions and our service will find up to three matches in your area. We fully vet all of our advisors, and they are free of disclosures. Each of your matches will then contact you so that you can ask them any questions and see if they are a match.
- GRATs are not the only type of trusts useful for legacy planning. While it doesn’t have the tax implications, setting up a standard revocable living trust can be useful.
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