Trusts can be a useful estate planning tool for creating and maintaining wealth for future generations. They can offer legal protections against creditors, while simultaneously managing assets according to your wishes. They may also enjoy certain tax advantages, further extending their benefits. Grantor trusts are a bit different from normal trusts, though. The income and assets in a grantor trust remain under the grantor’s control while they’re alive, resulting in taxes going to the grantor and not the trust. However, this type of structure may not be right for every person’s situation. A financial advisor who specializes in estate planning can help you determine whether you need a grantor trust.
What Is a Grantor Trust?
A grantor trust is a type of living trust, which means it takes effect during the lifetime of the individual who created it. According to the IRS, a grantor trust is one in which the grantor (the person establishing the trust) retains control over the trust’s income and assets. With this type of structure, the income from the trust is taxed to the grantor, not the trust itself.
IRS rules say that all revocable trusts, meaning trusts whose terms can be changed, are grantor trusts. A grantor trust can also be irrevocable if it meets certain IRS guidelines. With an irrevocable trust, the transfer of assets into the trust is permanent and cannot be undone by the trust grantor. Once a grantor trust becomes irrevocable, the trust is responsible for paying taxes on income generated by its assets.
Types of Grantor Trusts
There are numerous types of grantor trusts you can establish for estate planning. The type of grantor trust you choose may hinge on your financial needs and goals. No one estate plan covers all bases equally. But generally, you might consider one of these four options for establishing a grantor trust.
Revocable Living Trust
A revocable living trust may be the simplest type of grantor trust to understand. You create the trust, naming yourself or someone else as trustee. You then fund the trust by transferring assets to the trustee’s ownership. The trustee, which again can be yourself, is responsible for managing assets in the trust on behalf of its beneficiaries and your wishes. Since the trust is revocable, you can change its terms or terminate it altogether at any time.
Grantor Retained Annuity Trust (GRAT)
A grantor retained annuity trust or GRAT is a type of irrevocable trust which allows you to draw income from your assets. You transfer assets to the trust and receive annuity payments from it for a set number of years. Once this annuitization period ends, any remaining assets in the trust would go to its beneficiaries.
Qualified Personal Residence Trust (QPRT)
A qualified personal residence trust or QPRT is an estate planning tool that can be used to reduce taxes. This kind of trust allows you to transfer ownership of your primary home or second home to exclude its value from your taxable income. A QPRT might make sense if you have a home of substantial value that you want to pass on to future generations on a tax-advantaged basis.
Intentionally Defective Grantor Trust (IDGT)
An intentionally defective grantor trust is another type of irrevocable trust. It treats you as the asset owner for income tax purposes but not for estate tax. In other words, you’d pay income tax on trust assets during your lifetime. The assets exist separately from your estate when you pass away. This type of trust can help minimize estate and gift tax liability for wealthier families. While the trust is irrevocable, its grantor trust status offers more flexibility than a revocable living trust.
Pros and Cons of Grantor Trusts
On the pro side, the primary advantage of including a grantor trust in your financial plan is the potential to preserve wealth while minimizing taxes for your heirs. Typically, you’re better off from a tax perspective when paying income tax on trust assets at your own personal tax rate, versus allowing the trust to be taxed. The less you pay in taxes on trust income the better if you’re concerned with holding on to as much of your wealth as possible.
With certain types of grantor trusts, such as those mentioned earlier, you can get into more specific tax strategies for sheltering assets, such as a home. A grantor trust can also protect assets against creditors in a lawsuit. You can use a grantor trust to transfer assets for long-term care planning and assets held in a trust aren’t subject to the lengthy and sometimes expensive probate process when you pass away.
Establishing a grantor trust does have one major consideration, however. It assumes that you have the necessary financial resources to pay income tax obligations on trust assets during your lifetime. If you realize a large capital gain inside the trust, for instance, that could create problems at tax time if you don’t have the cash to cover your increased tax liability.
The rules surrounding grantor trusts could be changing, too. House Democrats are proposing to effectively end the use of grantor trusts by requiring trust assets to be included in a person’s taxable estate when they die. While trusts that are created before the law is exacted would be exempt from the change, any assets transferred to grandfathered trusts thereafter would be included in the grantor’s taxable estate.
There is an upside, however. If you have a grantor trust, you do have the ability to terminate grantor trust status if necessary.
Grantor Trust Rules
The grantor trust rules are outlined in the internal revenue code (IRC) to define tax implications and grantor trusts and how each should operate. The individual, according to these rules, that creates the grantor trust is the one that is taxed as the owner of any assets held within the trust.
Grantor trust rules outline how certain trusts should operate. The grantor trust agreement will outline how assets are managed after the owner of the grantor trust passes away. State laws can override some of the rules, for example in the determination of an irrevocable or revocable trust. Some other rules that are outlined by the IRS for grantor trusts include:
- The ability to add or change the party who is the beneficiary for the trust.
- The ability of the owner of the trust to change the trust’s composition.
- How assets can be added or subtracted from the trust.
- Whether the income from the trust can be used for purchases, such as life insurance.
- Who can, if anyone, borrow from the trust.
Who Needs a Grantor Trust?
Whether it makes sense to establish a grantor trust depends on the details of your financial situation. Setting up a trust could be the right move if you have a decent amount of assets and you want to minimize estate taxes on those assets for your heirs. You might also consider a grantor trust if you’re concerned about creditors attempting to attack your assets or you want to avoid probate altogether.
Like any type of trust, you may want to talk to an estate planning attorney before setting one up. This will help to ensure your needs and assets are taken care of after you’re gone. They can also help you decide which iteration of a grantor trust works best for your situation.
Grantor trusts can help minimize estate taxes for your heirs. Some grantor trusts are more complex than others. Some exist to serve a very specific function in estate planning. While not everyone needs a grantor trust, you may consider it when building your long-term financial plan. Enlisting the help of a financial advisor can make a huge difference in figuring out how you can make a grantor trust benefit your financial goals.
- Consider talking to your financial advisor about grantor trusts and what function they could serve for you. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Although you may not need a trust, there are other estate planning documents you’ll likely want to have. That includes a will specifying how you want your assets distributed. It also includes financial power of attorney and an advance health care directive. These are all things an estate planning attorney can help with drafting.
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