Establishing a trust as part of your financial plan can yield certain benefits, including the potential to minimize estate taxes. An intentionally defective grantor trust (IDGT) is a type of irrevocable trust that can be used to limit tax liability when transferring wealth to your heirs. This type of trust can be established to benefit your spouse, children, grandchildren and other descendants but it may be more appropriate in some situations than others. Getting to know the details of what an IDGT is and how it works can help you decide if it makes sense for you. Consider working with a financial advisor for your estate and retirement plans.
Intentionally Defective Grantor Trust Basics
An IDGT is a type of irrevocable grantor trust. An irrevocable trust is one that can’t be changed once it’s established. In other words, once you create the trust and transfer assets into it, those assets can’t be transferred back out again and the terms of the trust can’t be altered.
An IDGT allows you to remove assets permanently from your estate. Those assets are then managed by a trustee who is a fiduciary. The trustee’s role is to manage the assets in the trust on behalf of its beneficiaries, according to the terms you established in creating the trust.
What sets an IDGT apart from other types of trusts, such as a revocable living trust, is primarily the way in which assets in the trust are treated for tax purposes. Essentially, an IDGT allows you to transfer assets outside your estate, allowing you to avoid estate and gift taxes but not income tax.
Tax Benefits of an IDGT
An IDGT gets its name from its structure, which has an intentional flaw that’s designed to provide tax benefits for the trust grantor and his or her beneficiaries. In a nutshell, the trust is defective because you still pay income tax on the assets even though they’re no longer part of your estate.
When you create this type of trust, you’re freezing assets in the trust to help your beneficiaries avoid estate and gift tax. Since it’s irrevocable, those assets will stay in the trust until you pass away. In the meantime, assets in the trust can continue to appreciate in value, free from transfer taxes. However, you still pay income tax on the income generated by the assets in the trust.
An IDGT allows you to pick up the tax bill on trust income during your lifetime so your children or grandchildren aren’t stuck with it later after you pass away. Typically, no estate tax would apply at your death with this type of trust. Whether the gift tax would kick in would depend on the value of the assets in the trust and whether you used up your lifetime generation-skipping tax exemption limit.
How to Set Up an IDGT
Establishing an IDGT is something an estate planning attorney can help with. The steps are similar to creating any other type of trust. You’ll need to create the trust document, determine which assets will be transferred to the trust, name beneficiaries, outline the guidelines for managing the trust and name a trustee and one or more successor trustees.
In drafting an IDGT document, it’s important to be aware of any exceptions that could alter the trust’s status or result in assets being lumped in with the estate of the grantor (that’s you). When it’s time to fund an IDGT, there are two ways you can go about it.
First, you could make an irrevocable gift of assets to the trust. The types of assets you can gift into the trust may include real estate, investable assets like securities, collectibles, artwork and family heirlooms. Gifting assets that appreciate in value could be a good choice from a tax perspective since you can minimize taxation of those assets by placing them in the trust. But, depending on the value of the assets involved, this could trigger the gift tax.
The other option for funding an IDGT (and avoiding gift tax) is to sell assets to the trust, rather than gifting them. Since this is a type of grantor trust, you wouldn’t pay taxes on gains associated with the sale of assets since you’re essentially selling it to yourself. In the meantime, you receive an interest-bearing promissory note from the trust. You can draw on the interest as income or pay the interest into the trust to accumulate more wealth for your beneficiaries.
Who Should Create an IDGT?
This type of trust can be more complex to set up and maintain compared to a revocable living trust. For example, you could easily end up paying several thousand dollars to get the trust established, along with paying out a percentage of assets in the trust as a fee to the trustee each year.
The tax benefits tend to be greatest when you’re selling or gifting high-value assets to the trust that will continue to appreciate over time. For that reason, an IDGT may only make sense for high-net-worth or ultra-high-net-worth individuals who are seeking a tax shelter for assets. If you have a smaller estate and it’s unlikely that you’ll exhaust your lifetime exemption limits for estate and gift tax, then another type of trust may be a better fit.
The Bottom Line
An IDGT is one type of trust that can be a useful estate planning tool if you have a sizable estate and you want to insulate your heirs from estate and gift tax as much as possible. Setting up an IDGT is something that an estate planning attorney may need to help with to ensure the trust document is legal and correct. Adding assets to an irrevocable trust means considering carefully beforehand whether it’s the right choice for your estate plan.
Estate Planning Tips
- Consider talking to a financial advisor about whether an IDGT is something you need. If you don’t have a financial advisor yet, finding one doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted 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.
- Trusts can come in different varieties and serve different purposes inside an estate plan. Learn more about estate planning, who needs it and how to create an estate plan.
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