News & Information

Sign up here to receive our newsletter and other money saving tips.

Grantor Retained Annuity Trust (GRAT)

Grantor Retained Annuity Trust (GRAT)
A grantor retained annuity trust (GRAT) is an irrevocable trust into which you make a one-time transfer of property, and from which you receive a fixed amount annually for a specified number of years (the annuity period). At the end of the annuity period, the payments to you stop, and any property remaining in the trust passes to the persons you’ve named in the trust document as the remainder beneficiaries (e.g., your children), or the property can remain in the trust for their benefit.
A GRAT is generally used to transfer rapidly appreciating or high income-producing property to heirs with the main goal of transferring, free of federal gift tax, a portion of any appreciation in (or income earned by) the trust property during the annuity period.

The remaining beneficiaries may want to buy life insurance on your life to cover any taxes that may result from the inclusion of the GRAT property in your gross estate. If you die during the GRAT term, all of the property in the trust will be included in your estate for federal estate tax purposes. The advantages of the GRAT will be lost, and you will have incurred the costs of creating and maintaining the GRAT for nothing.

How the GRAT works
A GRAT is an irrevocable trust, when you transfer property to the GRAT, you’re making a taxable gift to the remainder beneficiaries. The value of the gift is discounted because of your retained interest. The amount of the discount is calculated using IRS valuation tables that assume the property in the trust will realize a certain rate of return during the annuity period. This assumed rate of return is known as Section 7520 rate, discount rate, or hurdle rate. If the property in the trust grows more than the IRS assumes it will, the excess growth will pass to the remainder beneficiary’s gift tax free. For Example, if you transfer a high yield investment portfolio worth $1 million to a GRAT that will pay you $117,000.00 at the end of each year for 10 years. If the Section 7520 rate is 3.0% your retained interest is valued at $998,033.00 and the taxable gift to the remainder beneficiaries is valued at $1967.00. You pay federal gift tax on $1,967.00 or offset this amount with your gift and estate tax exemption; to the extent it has not already been used. If the investment portfolio actually earned 3.0% annual return over the 10-year term, about $1967.00 will be left in the trust to distribute to the remainder beneficiaries. If the portfolio earns 5.0% annual return, about $157,281.00 will pass to the remainder beneficiaries (but the taxable gift will have been only $1967.00). If it earns 10.0% annual return, about $729,064.00 will pass to the remainder beneficiaries with the taxable gift still staying at $1967.00. The section 7520 rate is generally based on current risk-free interest rates. Thus, a GRAT can be especially attractive in a low interest rate environment.