The grantor retained annuity trust

There are many techniques available to successful families to transfer wealth from themselves to their children, grandchildren, or other beneficiary. A grantor retained annuity trust (GRAT) is an effective approach that can capture and transfer capital appreciation without generating gift or estate tax. The technique when done properly, expertly managed and complimented with a coherent, family communication plan can be a valuable tool in your Legacy Strategy.

Who should consider a GRAT?

The ideal candidate to take advantage of a GRAT has the following attributes:

• Sufficient wealth to support his/her lifestyle;
• Excess wealth that will surpass the federal lifetime estate/gift tax exemption;
• Desire to transfer excess wealth to children or family;
• Desire for a less complex planning approach;
• Possession of or intention to purchase assets with strong potential for appreciation; and/or
• Expected ability to sustain the trust for its entire term.

Tax implications of giving

If an individual desires to gift money to another family member, there are a few considerations and limitations to consider. Of course, an individual may transfer money from themselves to another family member by check, wire transfer, etc. This method is obviously simple, but will trigger a gift tax if it does not meet an exception. Exceptions (or nontaxable gifts) include:

• Gifts to political organizations, charities, tuition, or medical expenses you pay on behalf of another, or gifts to a spouse (if he/she is a U.S. citizen).
• Annual exclusion gifts allow you to gift up to $17,000 per year, per person tax free. For example, you could gift $34,000 to a husband and wife per year (2 individuals at $17,000 each) tax free.
• The federal lifetime exemption ($12,920,000 in 2023) is the amount of assets an individual may gift during their lifetime without incurring any gift tax. An important clarification is that any gift above the annual exclusion will reduce the donor’s lifetime exemption. To the extent you gift in excess of the annual exclusion and do not utilize your lifetime exemption, you will be subject to gift tax in that taxable year.
• The federal estate tax exemption ($12,920,000 in 2023) is the amount of assets an individual may transfer to family members, other individuals, or organizations upon their death via their estate. The lifetime exemption for gifting mentioned above is linked directly to the federal estate tax exemption. For example, if you gifted $1,500,000 of assets in excess of annual exclusion gifts during your lifetime, you will have $11,420,000 of exemption remaining ($12,920,000 less $1,500,000, inflation adjusted) at your death. Therefore, your testamentary estate will not be taxed on the first $11,420,000 of assets that pass to your heirs at death. Any assets in excess of the remaining exemption will be taxed at the maximum federal estate tax rate of 40%, (as of 2023). This ignores exposure to state estate or inheritance taxes.

How can a GRAT help?

The GRAT is a relatively simple estate planning technique that individuals may use in order to remove assets from their estate and avoid paying the U.S. gift and estate tax. Initially, the donor or grantor establishes an irrevocable trust into which they make their donation. This trust is set up as an annuity that pays an annual distribution to the donor/grantor for a fixed amount of time. After this set period has expired, the remaining capital or principal in the trust, typically the appreciation of the assets originally contributed to the trust, is awarded to the named beneficiary of the trust – generally a close family member.

When the GRAT is first established, the ‘gift value’ of the GRAT must be determined. This value is equal to the initial contribution plus a theoretical interest (determined by IRS regulations) earned on that contribution, subtracted by the annuity payments made through the GRAT’s term. Therefore, in order to maximize the tax benefit of the GRAT, the scheduled annuity payments should equal the ‘gift value’ of the donation. This will cause the gift value to equal zero, hence the term “Zeroed-out GRAT”. Whatever value remains in the GRAT (after all annuity payments have been made) passes to the beneficiary tax-free. The best assets to contribute are those that have the greatest chance of appreciating over the IRS theoretical interest rate. It should be noted that if the donor/grantor does not outlive the trust period, the GRAT assets will still be included in the grantor’s estate and therefore does not receive any tax benefit.

Zeroed-out GRAT example

An Investor/Grantor transfers appreciating assets worth $3 million to a GRAT for a five-year term. Based on the IRS prescribed interest rate of 3.82% (at the time the GRAT was created), the Grantor will receive an annuity of $670,106.54 per year for five years. At the end of the five-year term, (assuming a conservative annual growth rate of 6%) $757,784.19 of appreciation would shift to the Grantor’s children (gift and estate tax free). Note: The present value of the annuity that the Grantor received will be “equal” to the full value of the property that the Grantor originally transferred to the GRAT. (i.e., the GRAT is "zeroed out".). Accordingly, for gift tax purposes, the creation of the GRAT does not involve a gift.

SEI Private Wealth Management is an umbrella name for various wealth advisory services offered through SEI Investments Management Corporation (“SIMC”). 

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only and should not be interpreted as legal opinion or advice.

Neither SEI nor its affiliates provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor.

The information contained in this communication is not meant to substitute for a thorough estate planning and is not meant to be legal and/or estate advice. It is intended to provide you with a preliminary outline of your goals. Please consult your legal counsel for additional information. This is intended for educational purposes and not meant to be relied upon as investment advice.