A Grantor Retained Annuity Trust, or GRAT, is a financial tool that can transfer significant wealth to your heirs without incurring hefty estate taxes. For those with substantial assets, setting up a GRAT can be a smart move to save millions in potential taxes.
For example, my wife and I decided to set up a GRAT as a safety net for our children in case something unexpected happens to us. We wanted to avoid the public scrutiny and complications of probate court, and a GRAT helps maintain our financial privacy.
A friend of mine, whose net worth far exceeds the $11.4 million estate tax exemption per person, uses the GRAT as his primary strategy to manage his estate taxes efficiently. If executed correctly, a GRAT can shift considerable wealth to the next generation almost tax-free.
Here’s how it works: You, the grantor, transfer assets into the GRAT and receive a fixed annuity payment for a certain number of years. When the term ends, the remaining assets pass to your beneficiaries, typically your children. The initial transfer counts as a gift, but its taxable value is reduced by the annuity’s value. Ideally, this balance is structured so no taxable gift is left, known as a “zeroed-out” GRAT.
The key to a successful GRAT is setting the annuity payment based on the IRS-specified interest rate, known as the section 7520 rate. The lower this rate, the better the potential for significant tax savings. For instance, in January 2021, the rate was just 0.6%. A lower rate means any return on the GRAT’s assets over this percentage effectively passes to your heirs tax-free.
My friend, for example, used a GRAT to pass on his $10 million home to his children. He set it up in 2010, betting that the property’s value would outpace the 2% annual annuity rate. His bet paid off as the home appreciated significantly, outstripping the annuity payments and leading to substantial estate tax savings.
GRATs are versatile and can hold various asset types, from high-value real estate to stock portfolios or even parts of a business. In my case, I considered transferring my online business into a GRAT to eventually pass on to my son, with the potential for considerable growth over the annuity rate.
However, there are risks. If the asset growth doesn’t outpace the annuity rate, or if the grantor dies before the term ends, the benefits of a GRAT might be nullified. Also, setting up a GRAT requires legal help, which can be costly.
Who should consider a GRAT? It’s ideal for those with estates large enough to be concerned about future estate taxes. Given that the estate tax exemption and rates are at historically favorable levels, now might be a good time to consider this strategy.
Always consult with an estate planning expert to tailor a plan that fits your specific needs and circumstances. Changes in tax laws could affect the effectiveness of GRATs, so staying informed and proactive is crucial.
