What Is a Grantor Retained Annuity Trust?

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, you can gift larger sums of money with a reduced tax burden through 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.

If you’re thinking of using a GRAT, consider working with a financial advisor, you may want to get the help of a financial advisor. 

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:

1. The grantor establishes the trust and funds it with cash, securities or any other assets they want to pass on to beneficiaries.
2.  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. The IRS sets this interest rate each month.
3. 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 it makes all the annuity payments then the IRS considers the trust part of the estate. This means it is subject to estate taxes.

GRAT Example

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. Very wealthy families choose them when to pass large accounts from one generation to the next. These sums exceed the exemptions for the gift or estate tax, totaling tens of millions of dollars.

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 $13.99 million threshold for the federal estate tax. At the time of writing, the following states have an estate tax, according to the Tax Foundation: ¹

• Connecticut (12% on estates above $13.9 million)
• District of Columbia (11.2% to 16% on estates above $4.873 million)
• Hawaii (10% to 20% on estates above $5.49 million)
• Illinois (0.8% to 16% on estates above $4 million)
• Maine (8% to 12% on estates above $7 million)
• Maryland (0.8% to 16% on estate above $5 million)
• Massachusetts (0.8% to 16% on estates above $2 million)
• Minnesota (13% to 16% on estates above $3 million threshold)
• New York (3.06% to 16% on estates above $7.16 million)
• Oregon (10% to 16% on estates above $1 million)
• Rhode Island (0.8% to 16% on estates above $1.802 million)
• Washington (10% to 35% on estates above $3 million)
• Vermont (16% on estates above $5 million)

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.

How the 7520 Rate Affects GRAT Strategy and Timing

The 7520 rate is the single most important variable in determining whether a GRAT achieves its purpose, but it’s easy to overlook if you’re not familiar with how it works.

The IRS publishes the 7520 rate each month. It’s derived from the mid-term applicable federal rate and is used to calculate the present value of annuity payments and remainder interests in trusts. For GRAT purposes, it functions as a hurdle rate. It represents the growth the IRS assumes the trust assets will produce over the annuity period. Any actual appreciation above that assumed rate is what passes to beneficiaries without triggering gift tax.

Optimum GRAT Strategy

When the 7520 rate is low, the hurdle is lower. The IRS is assuming the assets won’t grow very quickly, which means even moderate investment returns can clear the bar. In that environment, there’s a better chance that value will be left over for beneficiaries after finishing the annuity payments. This is why GRATs attracted significant attention during periods when interest rates were near historic lows.

When the rate is higher, the math works differently. The trust assets need to outperform a steeper assumed growth rate. If the assets don’t clear that bar, all of the value goes back to the grantor through annuity payments and nothing is left for beneficiaries. The grantor is also out whatever they spent on legal and administrative costs to create the trust.

Because the rate resets monthly, timing matters. Some estate planning professionals track the 7520 rate and recommend establishing a GRAT during months when the rate drops. Others take a different approach, structuring a series of shorter-term rolling GRATs rather than a single longer-term trust. Rolling GRATs allow the grantor to navigate different rate environments and market conditions, rather than relying on one set of assumptions holding true over a longer period.

The type of asset placed in the trust also interacts with the rate. Assets with higher growth potential, such as concentrated stock positions or shares in a company approaching a liquidity event, are more likely to outperform the hurdle than stable, lower-growth holdings like bonds or cash equivalents. Selecting assets that have a realistic chance of appreciating beyond the assumed rate is just as important as choosing the right month to fund the trust. The two decisions work together, and getting one right while missing the other can leave the GRAT with nothing to transfer.

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. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• GRATs are not the only type of trust useful for legacy planning. While it doesn’t have the tax implications, setting up a standard revocable living trust can be useful.

Photo Credit: ©iStock.com/SARINYAPINNGAM, ©iStock.com/marchmeena29, ©iStock.com/Duncan_Andison