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Is a Grantor-Retained Annuity Trust (GRAT) a Smart Strategy for Reducing Estate Taxes?

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What is a Grantor-Retained Annuity Trust?

You will come across many options when choosing the most suitable estate planning tools for you. The ones you choose should meet your estate planning goals and be an appropriate match for the type of assets involved. Skilled estate planning attorneys in Pennsylvania can provide legal guidance on each tool and help you make a sound decision.

One of the tools is a Grantor-Retained Annuity Trust (GRAT), an irrevocable trust that allows you (the grantor) to pass assets to beneficiaries while significantly reducing the tax burden. The trust will enable acquisitions to appreciate and pass to the designated beneficiaries with little or no estate or gift taxes.

How Does a Grantor-Retained Annuity Trust Work?

GRATs can’t be revoked or altered, and due to their structure, they protect beneficiaries from taxes while guarding the estate from additional taxes. A GRAT works by freezing part of the estate’s value and passing future asset appreciation to heirs without being subject to estate tax.

Asset appreciation is protected by eliminating taxes on the growth when the money passes to the beneficiaries. Here’s the basic overview of a GRAT:

  • You move your assets into the GRAT for a set period, for example, ten years. A trustee oversees the trust and manages it for a pre-determined time.
  • You receive an annuity from the fund based on a percentage of the assets in the fund or a percentage of their growth according to the current interest rates. You can choose to receive smaller annuity payments at the beginning and increase them by a given percentage annually, leaving extra assets in the trust to appreciate over the GRAT’s term.
  • At the end of its lifespan, the remaining assets in the fund go to the beneficiaries without paying tax on the fund’s appreciation.

Before setting up a GRAT, it’s advisable to consult trust lawyers in Pennsylvania to establish other factors surrounding it and how they could affect your estate’s assets.

Types of GRATs

Grantor-Retained Annuity Trusts fall into two distinct types:

Zeroed Out GRATs

These are also known as Walton GRAT, and the sum of grantor annuities equals the value of the assets held in the trust. The GRAT results in a gift tax calculation of zero, making it possible for you to transfer income from the assets to your beneficiaries tax-free.

To implement the strategy, you accept combined payments equal to the trust’s entire value, including the anticipated appreciation. Theoretically, your beneficiaries would have nothing left. However, if the assets conveyed to the trust outperform the applicable 7520 rate, a rate published monthly by the IRS, a significant remainder could be transferred to the beneficiary free of taxation.

Rolling GRATs

Rolling GRATs are a series of short-term funds whose structure is that the principal amount remains in the trust longer. The initial distributions roll into subsequent trusts instead of being returned to the grantor. Subsequently, the grantor receives large allocations in the final years of the total term.

If a grantor passes away before the GRAT’s term expires, the remaining amount in the fund is added back to their estate and could be liable for estate taxes. A series of rolling short-term GRATs ensures only active GRATs are considered while the remaining amount goes to the beneficiary.

What Is the Tax Strategy of GRATs?

While GRATs can significantly help you reduce or eliminate taxes, they’re not completely tax-free and have some tax implications. Your estate planning lawyers in Pennsylvania should be able to discuss with you how taxes could affect your transfer of wealth:

Gift Tax

Upon transferring assets into a GRAT, you might owe gift taxes in the current year, depending on the presumed value of the remaining assets at the end of the annuity term. According to the IRS, your assets will be presumed to generate a rate of return tied to the applicable federal rate. The gift will reduce the lifetime estate tax exemption if the amount exceeds the $17,000 annual gift tax exclusion per beneficiary.

Income Tax

A GRAT is a grantor trust, and all income, losses, and gains will flow through to the grantor and be included in their personal income tax return. The advantage is that the strategy allows more wealth to be distributed to heirs because they don’t bear the responsibility of the tax payments. Secondly, the IRS rules out additional gift tax when a grantor pays income taxes.

Estate Tax

At the end of the GRAT’s term, the assets remaining in the fund are transferred to the beneficiaries. The transfer doesn’t affect the estate tax and isn’t taxable to the beneficiaries. However, one exception is if the grantor dies during the GRAT term or before all the annuity payments have been completed.

In that case, the GRAT’s appreciation will be included in the grantor’s estate. If you outlive the fund, the remainder won’t be taxable to you or your heirs.

A lot goes into establishing a GRAT, and it’s advisable to consult with skilled trust attorneys in Pennsylvania before setting up one. They can provide in-depth guidance on choosing the GRAT term, the assets to transfer to the fund, their expected appreciation, and how interest rates affect your investment.

A Skilled Trust Lawyer Helping You Set Up a Grantor-Retained Annuity Trust

GRATs can be excellent tools for planning your estate and can have a significant tax advantage. If you have a large estate that you wish to pass to your beneficiaries without the tax burden, a GRAT could be an excellent option to consider. Before setting up one, talk to experienced Pennsylvania trust attorneys to help you weigh the option against your type of estate.

Peak Legal Group, LTD, has responsive and down-to-earth estate planning and trust lawyers who can provide legal guidance and help you with your estate planning needs. We handle various estate planning tools and can help you select the most suitable depending on your needs and estate type to protect your future and family. Call us at 610-989-7064 to schedule a FREE consultation.

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