Trusts can be a useful estate planning tool for creating wealth for future generations. They can offer legal protections against creditors while managing assets according to your wishes. They may may also enjoy certain tax advantages. However, a grantor trust may not be right for every investor.
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, i.e. the person establishing the trust, retains control over 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 based on 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 be passed on 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 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.
There is an upside, however. If you have a grantor trust, you do have the ability to terminate grantor trust status if necessary.
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’ve accumulated a decent amount of assets and you want to minimize estate taxes on those assets for your heirs later. And you might also consider a grantor trust if you’re concerned about creditors attempting to attach your assets or you want to avoid probate. Talking to an estate planning attorney can help you determine whether you need a grantor trust and which type of trust is appropriate.
The Bottom Line
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.
- Consider talking to your financial advisor about grantor trusts and what function they could serve for you. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will 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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