Grantor Retained Annuity Trusts (GRATs) are a useful tool for minimizing estate taxes and keeping more wealth in the family over time. And direct indexing is an increasingly popular strategy for optimizing investment returns by purchasing individual stocks instead of a fund that owns an entire index. In this article, we’ll explain how you can pair the two to maximize the amount you pass on to future generations free of estate tax.
In the first article in this series, we discussed why 99 out of the 100 richest American families utilize Grantor Retained Annuity Trusts (GRATs) to reduce their estate taxes and pass on more wealth to future generations. In the process, we touched on several key concepts in GRAT planning and walked through a few scenarios to illustrate how GRATs work.
Here, we’ll explore direct indexing, an increasingly popular investment strategy, and explain how it can be paired with GRATs to supercharge the returns so that we can afterwards learn how, with Valur’s optimized “Direct-Indexed GRAT,” you can do even better, boosting how much your family is able to pass on by 98%, on average, compared to other GRAT strategies.
So let’s get started!
Direct Indexing Improves Investment Returns
Direct indexing takes the well-used concept of index fund investing a step further. Index fund investing is the strategy of owning a fund that replicates the performance of a sector, a geographical region, or even the entire stock market. With direct indexing, investors buy individual securities that replicate a particular index, rather than owning a fund that tracks the whole index.
Both direct indexing and index funds are trying to replicate a specific index, but they do so in different ways. With direct indexing, you directly own all the assets in an index with weighting that replicates the index while with an index fund, you own shares in a fund that itself owns individual stocks. While this seems like a insignificant difference, each strategy has its benefits and drawbacks. Direct indexing is more labor and cost intensive but can increase your returns substantially when combined with GRATs if used correctly.
You can learn more about index funds and direct indexing here.
Direct-Indexed GRATs Outperform The Traditional Version
In the traditional GRAT approach, you fund a single GRAT with a number of assets, such as an Index fund and this strategy could allow you to pass on some amount (the remainder) on to next generation estate tax free, as long as your assets go up over time and do it above the government 7250 rate. If youd like to understand the basic concepts of how GRATs work, we recommend you to visit our first article in this series.
But that traditional approach for GRATs is not the optimal approach. As we explained, combining assets into a single GRAT can cause the trust to underperform. (Recall scenario 3 from that last article, where the GRAT that combined Stock A and Stock B paid out a significantly smaller amount to your beneficiaries than separate GRATs, each holding one of the stocks in Scenario 1 + 2.)
The key insight is that separate GRATs, each holding a relatively volatile asset, will outperform a single GRAT holding all of those assets if even one of the assets fails to beat the 7520 rate.
We’ll explain why that is in some detail in the following sections. In the meantime, we’ll lead with this: Valur’s optimized “direct-indexed GRAT” strategy — in essence, a larger version of the “separate GRATs for each asset” strategy —can allow families to pass on 98% more assets free of estate tax while maintaining the same risk and asset exposure as investing in an index fund. In other words, without changing much about where you invest your money, your investments risks and the cost and overhead this strategy can more than double the wealth you leave for your beneficiaries.
How Does A Direct-Indexed GRAT Work?
Traditionally, a Grantor would place cash into a single GRAT and buy a single index fund — say, SPY, which tracks the performance of the S&P 500. That strategy is a net positive; assuming average annual S&P growth of around 9% and a historical 7520 interest rate of around 3%, this approach would yield about 6% per year for the Grantor’s beneficiaries estate tax free, with annual variations — maybe the index grows 20% one year and shrinks a few percent the next, but it’ll average out over time.
With Direct-Indexed GRATs, by contrast, you would take the same starting cash and, instead of buying a single index fund and placing it in a single GRAT, you’d follow a direct index strategy and open up separate GRATs that would own each individual stock in the index. If your index of choice is the S&P 500, that would mean ~500 separate stocks and, critically, ~500 separate GRATs (one for each stock). In the old world, this approach would have been prohibitively expensive. Valur solves that problem by leveraging technology to reduce the cost and effort; as a result, the cost of 500 Valur GRATs is comparable to the cost of 1 or 2 GRATs from a traditional service provider.)
Here’s how this strategy increases returns.
How Direct-Indexed GRATs Increase Returns By 98% Or More
If the traditional approach creates 6% expected returns per year for the Grantor’s beneficiaries, why would it make sense instead to go the direct-indexing route and take on the overhead of 500 separate investments and 500 separate trusts?
The short answer is that this approach takes advantage of several features of GRATs to yield far greater returns — 98% higher over the last 20 years — by maximizing the volatility in each GRAT. In fact, as a result of the basic rules of GRATs, it’s impossible for the combination of direct indexed GRATs to perform worse than a single GRAT that owns the same stocks via an index fund.
Let’s take a closer look at two key questions: (1) How direct indexing increases volatility and variance, and (2) why volatility and variance are good for GRAT performance.
How Does Direct Indexing Increase GRAT Volatility and Variance?
This part is simple. Let’s reuse the GRAT Scenarios we walked through in our first article in this series.
Imagine that you own $100 of one stock — Stock A — and the stock grows from $100 to $200 in the first year and stays at that value through the end of year 2. You also own $100 of one stock — Stock B —and the stock decreases from $100 to $50 in the first year and stays at that value through the end of year 2. Let’s also assume, as in our last example in our previous article, that the GRAT owes a first year annuity of 54%, based on a 5% 7520 rate, of the starting value (or amount the GRAT is funded with) and 54% of that starting value in the second year as the second year’s annuity. Anything left behind after that will be the remainder left for the beneficiaries estate tax free. Now if the GRAT runs out of money and can’t pay the owed annuity, the GRAT pays out as much as it can and ‘fails’ or ends.
The total value of both stocks combined started at $200 and grew to $250 — 25% growth over two years. But the results — most important, how much you leave as a remainder for your beneficiaries — depend on whether you owned an index fund in a single GRAT or a “direct index” of the individual stocks in different GRATs.
This is what we saw in the comparison of scenario where you owned both stocks in one combined GRAT, to both scenarios where you owned the stocks in separate GRATs.
In the scenario where you owned both stocks in one combined GRAT (scenario 3), the GRAT paid out an annuity of $216 and sent $34 to the beneficiaries.
| Scenario 3: 1 GRAT for Stock A + B | |
|---|---|
| Remainder Value | $34 |
| Annuity Payments | $216 |
| Year 1 Starting Value | $200 |
| Year 1 EOY Value | $250 |
| Year 1 Annuity Payment | $108 |
| Year 2 Starting & Ending Value | $142 |
| Year 2 Annuity Payment | $108 |
| Remainder | $34 |
First Year: Collectively, the stocks grow from $200 to $250. The GRAT owes an annuity equal to 54% of the starting value, or $108 (the same as the total annuity that was owed out of both GRATs in scenarios 1 and 2). After the first year, $142 are left in the GRAT ($250 – $108).
Second Year: The GRAT starts and ends the year with $142. The GRAT pays out its second annuity of $108, leaving $34 behind. As a result, this GRAT distributes $216 back to the Grantor and leaves only $34 for the beneficiaries.”
Now imagine that you place Stock A and B into separate GRATs. Instead of simple 25% growth in the single-GRAT scenario, here, the first trust (scenario 1) would be up 100% and the second (scenario 2) would be down 50%, making both GRATs more volatile than the combined version.
| Scenario 1: Stock A GRAT | Scenario 2: Stock B GRAT | Total | |
|---|---|---|---|
| Remainder Value | $92 | $0 | $92 |
| Annuity Payments | $108 | $50 | $158 |
| Year 1 Starting Value | $100 | $100 | $200 |
| Year 1 EOY Value | $200 | $50 | $250 |
| Year 1 Annuity Payment | $54 | $50 | $104 |
| Year 2 Starting Value | $146 | $0 (because nothing is left) | $146 |
| Year 2 Annuity Payment | $54 | $0 | $54 |
| Remainder | $92 | $0 | $92 |
Stock A
First Year: You start with $100 of Stock A, and that grows to $200 by the end of the first year. Drawing on the 7520 rate, we can calculate that the first-year annuity will be 54% of the starting value of $100, or $54. After the first year annuity is paid, $146 is left in the GRAT.
Second Year: You start the year with $146 of Stock A and end the year with the same amount. The GRAT pays out the same $54 annuity in the second year, leaving $92 in the trust. That $92 becomes the remainder value that passes on to your beneficiaries estate tax free
Stock B
First Year: You start with $100 of Stock B, and it loses value, falling to $50 in the first year. No matter the growth or decrease in value, though, the annuity is the same: 54% of the starting value of $100, or $54. But here’s why the trust’s performance matters: Because it lost so much value, it does not have enough to cover the first year’s payment, so we say that the GRAT “fails.” What does that mean? In these circumstances, the trust will pay out as much of the annuity as it can — here, $50, which is the total remaining after the first year — and then will be wound down, resulting in no remainder for the beneficiaries.
As you can see, we can say definitively that this separated scenario — the direct-indexed version with each stock in a different GRAT — will lead to ~3x greater returns for your family. (That’s the $92 remainder, which will go to your beneficiaries free of estate tax, as compared to the $34 remainder in the earlier, combined scenario.)
But why, and how?
Why Are Volatility and Variance Good For GRATs?
Volatility and variance are good for those pursuing the GRAT strategy because of the fundamental nature of these trusts: With GRATs, it’s “heads you win and tails you tie.”
What does this actually mean?
The basic rule of a GRAT is that any returns above the government’s interest rate will go to your beneficiaries free of estate and gift taxes. (You win.) If the trust does not outperform the 7520 rate, the trust’s assets will just come back to you in the form of your annual annuity distributions, and you can try again. (You tie, since you can simply put those assets back into the next GRAT and play the GRAT game again.)
It should be clear, then, why volatility and variance are better: There is real upside to large returns in an individual GRAT, and there is quite literally no downside to negative returns (for GRAT purposes — everything else equal, you would, of course, prefer positive returns).
A Simple Example
Let’s walk through a simple scenario. Imagine that you set up two successive two-year GRATs subject to a 5% 7520 rate (One GRAT starts now and the second one starts in 2 years when the first GRAT ends with the annuities from the first GRAT rolling over to fund the second GRAT – you can learn more about rolling GRATs).
- Scenario 1: Over the first two years — the term of the first GRAT — the trust’s assets grow 5% every year and are worth ~111% of the original value at the end. The trust pays out no remainder, because it didn’t grow any faster than the 5% 7520 rate, so you receive the full amount back as the annuity. You then take the whole amount and place it into another GRAT in which the assets also grow 5%/year, but that trust, too, fails to outperform the 7520 rate, so you just get your principal and interest back and nothing goes to your beneficiaries.
- Scenario 2: Over the first two years — the term of the first GRAT — the trust’s assets grow 10% annually, so by the end of this first term they are worth ~121% of the original value. Because this trust outperformed the 7520 rate, about 10% of the assets would go to your beneficiaries estate tax free, and 111% would come back to you as the annuity. Now suppose that over the next two years, the second GRAT’s assets don’t grow at all. You would not have outperformed the 7520 rate, and there would be no annuity from that second two-year trust.
Critically, in both scenarios the assets grew about 21% over 4 years. But because the second scenario saw more volatility and more variation in growth — 10% for two years and 0% for two years, as compared to a straight 5% each year — it outperformed the 7520 rate for the term of one trust and, therefore, left behind a remainder that passes on estate tax free. And even though the second trust performed worse in subsequent years, that happened in a separate, independent GRAT and did not impact the results of the first GRAT.
The picture should be becoming clear. Direct-indexed GRATs are a broader version of this strategy: Divide your GRATs to achieve more volatility and variation in performance, and outperform the naive, combined approach. Please read our next article to understand how you can take advantage of Direct Indexing GRATs.
Conclusion
If there’s anything you take away from this article its the importance of volatility and variance in maximizing a GRAT’s performance and how much you pass on to future generations. Valur’s Direct-Indexed GRATs, which combine GRATs with direct indexing are built to maximize the GRAT’s volatility and as a result can increase returns by 98% or more, while maintaining the same risk and asset exposure as investing in an index fund.
Next Steps
You’ve read up on the basics of a GRAT, and now you know more about how Grantor Retained Annuity Trust rules. If you’re interested in going deeper still, then, access our calculator to evaluate the potential return on investment given your situation, or schedule a meeting with us.
About Valur
We’ve built a platform to give everyone access to the tax and wealth building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures so you can build your wealth more efficiently at less than half the cost of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $1.1 billion in additional wealth for our customers.
If you would like to learn more, please feel free to explore our Learning Center, check out your potential tax savings with our online calculators, or schedule a time to chat with us!