The largest wealth transfer in history is expected over the next two decades: About $30 trillion will pass from Baby Boomers to Millennials. As this happens, both generations will be looking at how best to pass on those assets as efficiently as possible – that is, ensure as much as possible passes to their heirs by minimizing the money lost to taxes.
The estate tax can be a significant barrier to passing wealth between generations: you may pass on $12.06 million free of federal taxes (or double that if you are married), but every additional dollar gifted will be taxed, with the tax topping out at 40%. And that’s just the federal estate tax; almost half of the states have their own regimes that can tack on an additional tax of between 10% and 20%. All in, then, your heirs could owe as much as 60% taxes on the assets you pass on, drastically shrinking the legacy you thought you were leaving behind.
But it doesn’t have to be that way. Different planning strategies can help people with large estates maximize their families’ returns when assets are passed to the younger generations. In this guide, we’ll focus on the one that works best for most of our clients: the Grantor Retained Annuity Trust.
More than half of the 100 wealthiest American families use Grantor Retained Annuity Trusts and other similar trusts to reduce or eliminate their estate taxes. So why has this structure become the tool of choice for the nation’s financial elite?
A GRAT is a trust – in essence, just a financial tool – that allows an individual to pass assets to others – usually their children or grandchildren – tax free.
How? GRATs work like this: The trust’s creator – the “grantor” – puts assets into the trust for a fixed period and a portion of that principal is returned to the grantor every year so that, by the end of the term, the original principal has been returned to him/her.
But wait, if the grantor is just getting the original principal back, what’s the point? The magic of a GRAT is in the difference between what the grantor is required to withdraw as an annuity and how much the assets actually grow while they’re in the trust. The IRS requires that the trust pay the grantor an annuity that grows with the government’s statutory interest rate. If the trust’s assets grow faster than that, there will be money left in the trust at the end of the term. And that amount may be sent to the grantor’s beneficiaries tax free.
That move is a bit complicated, so let’s break it down idea by idea:
What kind of assets? GRAT users typically choose to put a single asset in each GRAT that they expect to appreciate significantly over the trust’s term.
A single asset is common because the GRAT’s expected returns will be highest if the trust’s assets significantly outperform the statutory interest rate, and there’s little downside (in tax terms) from an investment’s failing to grow. For these reasons, aggressive, concentrated investing usually makes the most sense.
The same goes for the risk profile of the asset: High-risk, high-reward investments (individual public company stock, shares in a startup, interest in a small business, cryptocurrency, carried interest or real estate, for example) are a good fit for a GRAT because you’re looking to maximize growth, no matter the downside risk.
We’ll show you the math behind both of these points in a minute.
The most common term for a GRAT is a few years. Why so short a term? Two reasons:
The first has to do with the expected return profile of GRAT assets. GRATs are designed to distribute any gains above the original contribution (plus interest) to their heirs free of estate taxes. A long-term trust runs the risk of becoming a “failed GRAT” – essentially, a trust whose investments never catch up to the statutory interest rate. That can happen, for example, if the asset’s value declines in the first few years of a long-term GRAT and never recovers. With a short-term GRAT, this risk is lessened; if the trust’s investments decline early, the trust may end in failure, but you can simply start over sooner by putting the assets in a new GRAT. (This is a key feature of GRATs: “Failure” just means you receive your assets back, as if you had never formed the trust in the first place and this is why GRATs are by their “heads you win, tails you tie” value proposition.)
The second reason for choosing short-term GRATs has to do with mortality risk. It’s a tough subject, but the simple fact is that a GRAT may not pay out to the beneficiaries unless the grantor is alive at the end. The longer your trust, the more likely it is that the grantor doesn't make it to the end.
The trust must make a defined payout to the grantor (you) each year, and those payments must be structured such that you will expect, by the end of the trust’s term, to distribute the entire “net present value” of the assets contributed to the trust. We’ll explain the math, but it’s enough to know that those payouts will typically start relatively small and will increase over the term of the trust.
If the trust’s assets grow faster than the government’s statutory interest rate (currently 3%), there will be money left in the trust at the end of the term. That amount may be sent to the grantor’s beneficiaries tax free.
3. How does the GRAT remainder interest end up tax free?
GRATs are a powerful tool for passing assets to your beneficiaries, and their value lies in the ability to distribute the trust’s remainder interest free of gift tax.
The GRAT’s value – the key arbitrage – is that any growth above the IRS’s assumed interest rate will be tax free. How does that work?
GRATs are simply a tool for paying the gift transfer tax up front on assets that you are promising to give your beneficiaries in the future. If you promise to send $1 to your family in the future, the IRS is going to require that you pay any gift tax due on that $1 gift.
But that $1 gift isn’t actually worth only $1; the IRS expects it to grow between the day you promise it and the day you actually hand it over to your beneficiaries. How much does the government expect the gift to grow? The IRS uses the “7520 rate,” which is a statutory interest rate used to calculate all manner of government interest, annuities, and other financial terms. At the time of writing, that interest rate was 3.0%, which means the government expects trust assets to annually grow at 3.0% over the life of the trust. So a $1 gift today, to the government, is worth $1.03 in next year’s dollars, and about $1.06 after two years, and about $1.10 after 3 years. That $1.10 is the value, for gift tax purposes, of today’s $1 that you promise to gift to your beneficiaries after year 3.
But what if your trust’s investments grow faster than the 3.0% government rate? By rule, any appreciation in excess of the government’s statutory interest rate is, essentially, nonexistent for gift tax purposes, so that excess appreciation passes to the beneficiaries free of gift tax and that’s the power of the GRAT.
That arbitrage depends on your trust’s investments growing faster than the government’s statutory interest rate. The greater that difference, the more assets will pass to your beneficiaries tax free. It’s not tough to see, then, that this will most likely pay off when interest rates are low or when you put in assets that are either under valued or expected to appreciate significantly, as it is easier for your investment growth to outpace the government 7520 rate.
What happens if it doesn’t outpace the government rate or worse, your assets actually decline in value? Asset depreciation may be a problem for your portfolio, but there are no extra special repercussions from using a GRAT. If the trust’s investments don’t outdo the government rate, you would simply receive your distributions, and there would be nothing left for your beneficiaries. This would put you in the same position you would have been in if you hadn’t set up the trust; this hedge, again, is why the GRAT is known for creating a “heads you win, tails you tie” outcome.
If the whole point of a GRAT is to promise $1 today, pay gift tax on the expected value of that $1 in a few years, and send any excess appreciation to your beneficiaries free of gift tax, why not just give away that $1 today and let your beneficiaries choose what to do with it?
The answer is simple: If you took that approach, your beneficiaries would be on the hook for capital gain taxes on those assets’ appreciation. With a GRAT, by contrast, the grantor owes – or, to put it more charitably, is allowed to pay – the taxes on any capital gains realized during the trust’s term. This is advantageous because the goal is for the grantor to take as much of the tax burden as possible off of the beneficiary’s shoulders. By passing appreciated assets to heirs tax free and paying income taxes up front, you are able to reduce the assets in your estate, minimize the gift taxes you pay, and maximize the amount that will be left for your heirs.
With those basics out of the way, let's take a deeper look at how GRATs can do even more work for you. (And if you’re still not feeling solid on those basics, go ahead and schedule some time with our team.)
A basic GRAT – the kind of trust you’d get if you went to any estate-planning lawyer in your hometown – has the virtue of being simple: You set up the trust for, say, 10 years, you put some assets in, the trust pays you a fixed annuity, and at the end of the term you check to see whether the trust’s investments outperformed the government’s interest rate. If they did, your beneficiaries will get to take home some money tax free.
But you can do better. There are three key ways to improve on the basic GRAT to substantially increase your final returns:
GRATs are required to make annual distributions to the grantor. The only requirement here is that these distributions add up to an amount equal to the total value of the initial trust principal (in inflation-adjusted terms).
The basic approach might be to make equal annual payouts each year to reach that target number. But you can improve your returns by choosing an increasing payout schedule. By starting with a smaller payout in year 1 and growing it each year until the GRAT ends, you reach the same total payout, but you keep more assets in the trust to grow for longer. For example, if your trust is required to pay out $1M over 5 years, you could pay $200k per year, so that by the end of year 4, your trust has leaked $800k back to you and has a small amount still in the trust, compounding. Or the trust could pay $135k in the first year, and a 20% larger distribution each year. (The IRS allows payments to grow by at most 20% per year.) Using this approach, you’d have an additional $65k in the trust after the first year, and you could reinvest and grow that amount (and the additional savings each subsequent year).
You can achieve 100% tax-free gifting by ensuring that the present value of the trust’s annual distributions over the trust’s term are equal to the total value of the property used to fund the trust. Since you (the grantor) receive an annuity that is equal to what you contribute to the trust, the IRS expects the amount left for your beneficiaries to equal $0. Given this is a zero-value gift from the IRS’s perspective (though not in reality, because you expect your investments to grow faster than the IRS’s interest rate), you won’t be required to use any portion of your lifetime gift tax exemption. Instead, any assets remaining in the GRAT after the final annuity payment will pass to your remainder beneficiaries tax free.
As we explained earlier, long-term GRATs come with some risks, including the risk that the trust’s investments will not keep up with the statutory interest rate or that you could pass away before the trust’s term ends.
To reduce those risks, best practice is to set up a series of short-duration trusts every year, and for the annual distributions from each trust to “roll” into a new GRAT.
We’ll present a detailed example with numbers shortly, but how does this work in theory? The Rolling GRAT strategy consists of successive short-duration Zeroed-Out GRATs established in sequence. The grantor establishes an initial GRAT for a short duration – say, two years. The grantor will receive two payments from that GRAT, one in each year of the trust’s term. At the end of year 1, the grantor will use that year’s distribution to fund a second, identical GRAT. The grantor will now have two trusts operating with the same strategy. And there’s no reason to stop there. You can roll each year’s distribution into a new GRAT, with the goal of moving substantially all of your assets to your beneficiaries over time.
In this way, you can replicate the dollar value of a long-term GRAT, but with much less of the risk we outlined above.
Having gone one level deeper, let’s now spend some time with a detailed case study.
Billy is a successful investor. He has accumulated well over $15M of assets at this point in his life, and, realizing that he and his family are going to be subject to significant estate taxes when he passes those assets on, he has decided to start estate planning early. His goal is to maximize how much wealth he can transfer to his children while minimizing the associated taxes.
To do that, Billy decides to pursue a rolling Zeroed-Out GRAT strategy, with each GRAT lasting for 2 years.
Assumptions:
Working with those assumptions, here are the results:
Based on the assumptions above, over a 38-year period, Billy will have distributed $33.2M to his beneficiaries free of estate tax.
If, instead, he had pursued the same investment strategy but kept the funds in a normal, taxable account, he would have paid 40% estate tax (the highest tier) before transferring those funds to his beneficiaries. As a result, instead of giving his heirs $33.2M over the years, he would have left them $19.9M. Quite a difference at the end of the term!
GRATs are an excellent vehicle for transferring appreciation to beneficiaries with little to no gift tax. They work especially well when interest rates are low, as they are now, and can be structured with substantial upside and little downside. (If the assets decline during the length of the GRAT, grantors would only end up distributing their assets back to themselves while leaving nothing to their beneficiaries.)
With a rolling GRAT strategy, you can effectively replicate the initial approach of setting up a GRAT, while reducing the individual risks associated. The truth is, a rolling Zeroed-out GRAT strategy is the most effective at ensuring these GRAT strategies ultimately provide value for the grantor and his/her beneficiaries.
If your net worth is above the lifetime gift- and estate-tax exemption, don’t miss out this strategy.
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