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Zeroed Out GRAT: A Method To Minimize Your Estate Tax

If you got to this point, you’re probably familiarized with estate taxes, and have been exposed to them. But now you have to make the right decisions to help your assets transfer and grow tax-free successfully. You can do this through the application of the Zeroed Out GRAT (or zeroed-out grantor retained annuity trust) strategy.

Let’s recap! A GRAT (Grantor Retained Annuity Trust) is a powerful estate planning structure that allows individuals and families to eliminate estate taxes as they pass assets on to the next generation. The mechanics are simple: An individual makes an initial contribution to a GRAT and receives annual payments from the trust. At the end of the trust’s term, the initial contribution is paid back to the person who set up the trust, and the remaining assets (whatever growth the individual achieved during the trust’s term) are distributed to the beneficiaries (typically children or other family members) free of estate tax.

What is a Zeroed Out GRAT?

A zeroed out GRAT (Grantor Retained Annuity Trust) is a type of trust that allows you to transfer assets to beneficiaries without gift or estate taxes. With a zeroed out GRAT, the trust terminates upon the death of the person who created it and all of the assets transferred to the trust are given to the beneficiaries tax-free. This is a popular option for people who want to leave a large sum of money to their heirs without having to pay any taxes on the transfer. But why?

setting the zeroed out GRAT annual distributions helps decrease your taxes significantly. Therefore, the goal is to reach a zero estate tax on the amount passed to beneficiaries. These GRATs are a small but powerful optimization for your trust.

How do Zeroed Out GRATs Work?

How is your estate tax determined? If you don’t do any special planning, your family will owe federal taxes on every dollar over the estate-tax exemption ($12.06 million for individuals and $24.12 million for married couples as of 2022) that goes from you to your beneficiaries when you pass away.

With a GRAT, you will owe tax on only a fraction of those gifted dollars. This is the magic of a GRAT: As long as the trust pays you back the initial value plus the government mandated interest rate, you are allowed to pass on everything left in the trust to your beneficiaries tax free. Stated differently, your estate tax exposure with a GRAT will be equal to the difference between (the total trust value + interest) and (the amount you actually receive over the trust’s term).

But let’s take a zeroed out GRAT. Say you set up a 2-year trust with a $10 million initial contribution and two scheduled distributions of $5 million each. Using the government’s 3% interest rate (as of May 2022), you would have been expected to withdraw $5.22 million per year instead. From the government’s point of view, then, you will have given an extra $600,000 to your beneficiaries, and that amount will count against your lifetime estate tax exemption or, if you’ve already used it up, you’d owe gift tax immediately — as much as $259,000!

How could a zeroed out GRAT help reduce the estate tax to zero?

Fortunately, yes! Tere’s an easy fix: Sticking with our running example, if you set the annual payment at $5.22 million instead, then there would be no excess gift, and you wouldn’t use up any of your gift exemption. Accordingly, any additional asset growth above 3% would pass to your beneficiaries free of estate tax.

Zeroed-out GRAT example

That’s fairly abstract, so lets walk through a real-life example. Garrett, 49, a successful serial entrepreneur, has accumulated well over $50 million of assets, so he expects to use his full lifetime gift tax exemption and pay at least some estate tax. It’s never too late to start estate planning, though, so he decides to set up a single zeroed-out GRAT to test the waters.

Setting up and funding the trust. Garrett’s decided that he wants to set up a 4-year trust, and he contributes $20 million.

Preparing for annual distributions. Because Garrett set up a 4-year trust, most planners would set him up with an annual distribution equal to $5 million, or 1/4th of the original amount contributed to the trust. If he did that, though, he would end up using a significant portion of his lifetime gift tax exemption. For that reason, a zeroed-out GRAT would make more sense. Garrett will take an annual payout of $5 million plus the IRS’s interest rate of 3.0%, or $5.38 million. As a result, he will use up none of his exemption and pay no estate tax on whatever additional growth he passes on to his beneficiaries.

Investing the trust assets. Garrett is a savvy investor and is able to achieve a 10% annual return on his assets, on average, over the course of the 4-year trust.

The outcome.  At the end of the 4 years, after the GRAT has distributed $5.38 million per year or $21.52 million total, about $4.2 million of investment gains would be remaining. All of that money would go to Garrett’s designated beneficiaries, entirely free of federal estate tax. To maximize how much he can pass on to his beneficiaries, Garret would use a series of rolling zeroed-out GRATs (combining the articles share in this article and the previous article on rolling GRATs).

Are there any potential improvements to the basic GRAT?

There are! We’ve highlighted, for example, how the rolling, short-term version can improve outcomes. But there’s an even more basic move that will help you entirely eliminate your family’s estate tax bill. This strategy is commonly known as “zeroing out,” and it simply means setting the GRAT’s annual distributions so that the estate tax on the amount passed to beneficiaries is zero. It’s a small but powerful optimization.

What happens if you miss a GRAT annuity payment?

If you miss one of these payments, you (the grantor) would be violating the IRS 2702 Section: The trustee fails to pay the annuity to the grantor within the grace period, which is 105 days. Additional contributions can only be made after the GRAT is established. Plus, the annual payment could increase over a 120% in the last year of the trust.

Next Steps

Zeroed-out GRATs are a highly effective estate planning tool that can minimize your estate tax paid while maximizing the benefit to your heirs. Individuals looking to maximize their gifts to the next generation, while maintaining minimal exposure to estate taxes should consider use of this tool. At Valur, our goal is to make the GRAT planning process simple and easy. We’ll do the math, draft your trust, and handle the annual distributions, accounting, and other administrative tasks, all so you can focus on what matters.

Schedule a time to chat with our team, or try our calculator at no cost and with no commitment!

About Valur

We built a platform to give everyone access to the tax and wealth building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. 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 it easy and have helped create more than $500m in wealth for our customers.