Likely by now you’ve read out foundational posts on GRATs, if you haven’t then you should pause and go back to read those. Our GRAT primer focuses on the essentials, while our Advanced GRAT strategies articles dive into the optimized approach for maximizing the value of these estate planning tools. But this time, we’ve focused on all the GRAT questions that might pop-up on your mind while reading through our content.
Inevitably we know there are going to be questions as individuals read these articles and likely you’ve come here seeking answers. Well you’re in luck.. We’ve compiled the most frequently asked GRAT questions below for your convenience.
Why do shorter length trusts make sense?
The simple answer is less risk. GRATs are designed to distribute any gains above the asset value your originally contributed. So if you contribute $1m to a GRAT, then you’re expected to pull out at least $1m over the life of it. If you set up a 10 year GRAT, and the assets declined in the first few years, you might find a situation where you have assets locked in the GRAT but unfortunately lower odds that you’ll distribute anything to your beneficiaries, as you have to make up that growth. Having a shorter length trust minimizes the risks of having a “losing” GRAT, where you end up taking all of the assets back but leave nothing at the end for the beneficiaries.
What is the “7520 rate” and how does it impact the trust?
The 7520 rate is practically the IRS’ version of a discount rate. It varies from month-to-month and is a foundational aspect of tax/estate planning trusts. Within the context of GRATs, it’s essentially the growth rate that the IRS will use when it comes to calculating the growth of the assets throughout the term of the trust. So if you have $10m in a 4 year GRAT, the IRS expects those assets to grow 2.0% (as of Mar 2022) per year. Any growth above the 7520 rate, or 2.0% in this example, is what the beneficiary gets to keep at the end of the trust.
Why should a GRAT contain only a single asset class?
These trusts are designed for high growth assets, with the goal being to grow quickly and distribute significant gains to your beneficiaries. By diversifying you do minimize the risk of losing principal/assets, but you also reduce the likelihood of choosing a winning GRAT strategy. Using a shorter term GRAT, with a single asset, tends to grant you the highest likelihood of success.
What happens if my asset value actually declines?
Beyond the fact that you would technically lose money, there is no negative repercussions for the GRAT or you. You would end up distributing the entire sum of cash back to yourself while leaving nothing for the beneficiaries. If you’re using anything other than a zeroed-out GRAT, you would have paid some estate tax for what ultimately amounts to no real gift and thus losing some of your lifetime gift tax exemption if you hadn’t already used.
What are the rules of increasing payments and how do they work?
Increasing payments are a simple mechanism with GRATs that allow them to potentially be higher returning vehicles, by forcing lower payouts in earlier years and pushing larger payouts until later years. This effectively allows the assets to continue growing in the trust longer. The only rule that applies is that you’re not allowed to grown an individual year’s payment by more than 20% over the prior year. This effectively prevents you from paying $1 each year to start and then paying large sums in later years. Short term GRAT strategies benefit less from increasing payment methodologies.
How do estate taxes work?
Most simply put if your estate is an excess of a certain amount, you will owe estate taxes on any amount above the federal estate- and gift-tax exemption. For 2022, the lifetime exemption fo both gift and estate taxes is $12.06 million per individual, or $24.12 million per couple. So for example, if you had an estate at $50 million at the time of your passing, you would ultimately pay 40% taxes on $25.88 million, before your heirs receive any funds. The first $24.12 million they would receive estate tax free.
How are gains taxed?
You as the grantor are the one that will be taxed on gains, if you sell assets to make distributions to your beneficiaries. Thankfully if you’re using a GRAT, you’re typically trying to reduce your taxable estate, and what better way to do so than paying taxes on assets you transfer to your beneficiaries? Alternatively, a more advanced approach, is transferring assets in-kind to your beneficiaries and allow them to sell when they’d like. This would ultimately defer taxes even further until a beneficiary is ready to sell those assets, and depending on their net worth, could be a good fit to place those assets in a Charitable Remainder Trust.
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