What Are Grantor Retained Annuity Trusts (GRATs)?

This topic recently came up in a discussion with a client.  We thought it beneficially to share our insights on Grantor Retained Annuity Trusts.  For many people, passing on wealth to future generations is a top priority. There are many ways to do this through proper estate planning, and one of these strategies is to create a grantor-retained annuity trust or GRAT. 

Let’s look at what a GRAT is, how it works, and help you determine whether it suits your financial situation.

What is a Grantor Retained Annuity Trust?

For many people, passing on wealth to future generations is a top priority. There are many ways to do this through proper estate planning, and one of these strategies is to create a grantor-retained annuity trust or GRAT. Let’s look at what a GRAT is, look at how it works, and help you determine whether it would suit your financial situation.^1,2

To set up a GRAT, the grantor must set up an irrevocable trust for a certain timeframe. Assets are placed in that trust, and an annuity is paid out to the grantor every year. When the trust expires, the beneficiary receives the remaining assets and pays little to no gift taxes. 

When creating a GRAT, the grantor puts the assets in a trust but still receives the original value of the assets while earning a rate of return established by the IRS. This rate, called the 7520 rate, is used to value certain charitable interests in trusts. As of April 2024, this rate is 5.2%.^3,4

What Assets Can You Put in a GRAT?

You can put virtually any type of asset in a GRAT, but the most efficient way of using a GRAT is to place assets in it that you think will increase in value over the annuity term. This could be real estate or stock in a pre-IPO or IPO company that you think will increase substantially in value. This is because only the appreciation transfers to the beneficiary at the end of the term.

Let’s look at an example. Say you put $1 million of stock in a GRAT and set the term length for four years. Then, you get a $250,000 annuity payment per year (4 x $250k = $1 million) plus interest (the aforementioned 7520 rate). At the end of the term, your beneficiary receives the appreciation of that asset over the 4 years of the term. Because it’s only appreciation, the IRS doesn’t consider it a gift, and it is thus exempt from gift tax.

The Benefits of GRATs

The main benefit of GRATs is that they allow you to pass along more wealth to your heirs and avoid paying a gift tax of up to 40%. This benefit is why so many wealthy individuals choose to create GRATs.⁵

GRATs are especially beneficial in a low-interest market.

Considerations of GRATs

As with any financial decision, there are considerations to be taken into account when setting up a GRAT. The first is that rising interest rates and market valuations could reduce its effectiveness. Also, potential tax legislation changes could alter its benefits and structure.

Is a GRAT Right for You?

Depending on your situation, a GRAT could be a good option for you to pass down wealth to your heirs tax-free. Talk to your estate planning attorney to see if a GRAT could make sense for your overall plan.