Irrevocable Life Insurance Trust (ILITs) and Grantor Retained Annuity Trusts (GRATs) are two popular types of irrevocable trusts. How do you know which one is right for you? This article explains what these trusts are and when they make sense.

Key Highlights and Takeaways

• Two Powerful Estate Tax Strategies: ILITs and GRATs both save estate tax, but they’re used in different circumstances.
• ILITs are Extremely Tax Efficient: ILITs are highly tax efficient. The trust shelters the life insurance proceeds from estate tax, while the life insurance wrapper shelters the investment returns inside the policy from income tax.
• GRATs Efficiently Transfer Volatile Assets: GRATs are ideal for people with volatile, liquid assets who are looking to transfer assets to their children. GRATs transfer assets using an IRS-sanctioned formula where returns above a certain baseline are allowed to pass to the donor’s heirs.

What is an ILIT?

An ILIT is a type of irrevocable trust that is designed to hold insurance. A person (the “grantor”) creates an ILIT for the benefit of one or more loved ones — such as children, grandchildren, a spouse, or siblings. Typically, the grantor funds the trust with cash, which the trust uses to acquire one or more life insurance policies, often on the grantor’s life. Once the life insurance policy is in the trust, it is outside of the grantor’s estate, and the proceeds will not be subject to gift tax, estate tax, or generation-skipping transfer tax. Because life insurance policies generally are not subject to income tax, ILITs are able to generate both income-tax savings (via the insurance policy) and estate-tax savings (via the trust). It’s possible for ILITs to own assets aside from life insurance, though generally they stick to holding life insurance policies plus a small amount of liquidity.

ILITs can hold any type of life insurance policy, from indexed universal life insurance (IUL) to term life insurance. But a specific type of variable universal life insurance policy, known as Private Placement Life Insurance (PPLI), works particularly well with ILITs and has become quite popular with high-net-worth individuals who are looking to transfer as much post-tax wealth to their family members as possible. Even after accounting for the fees that life insurance companies charge, an ILIT funded with PPLI will generally outperform other estate-tax strategies. (You can learn more about ILITs here.)

ILIT Example

Imagine that Ronald is a 40-year-old New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If Ronald sets up an ILIT and then contributes $6 million to fund premiums on a PPLI policy, he will use up $6 million of his lifetime gift tax exemption, but the investments in the life insurance policy will be able to grow outside of his taxable estate. Even after fees, the policy will generate more than 8% annual post-tax returns. Meanwhile, the insurance charges will pay for a generous death benefit. If Ronald dies in Year 25, his beneficiaries will receive roughly $59.9 million of cash proceeds from the ILIT, and the total tax savings for his heirs will be about $39.9 million relative to if Ronald had done nothing.

Benefits of ILITs

1. Estate Tax Savings: The primary advantage of an ILIT is that it can shelter the proceeds of life insurance policies from estate tax upon the grantor’s death. Since the federal estate rate is 40% and in some states the effective estate tax rates (federal + state) are as high as 52%, this is an important benefit. When PPLI and ILITs are used in conjunction, the combined tax savings can be quite significant.
2. Asset Protection: An ILIT, as a separate legal person, is generally not subject to liability for actions taken by a trust’s grantor or beneficiary. So the grantor’s or beneficiary’s creditors won’t be able to access the trust’s assets even if they win a lawsuit against the grantor or beneficiary. In addition to protecting assets from lawsuits, ILITs can help shield inherited assets from a divorcing spouse.
3. GST Efficiency: A person can allocate generation-skipping transfer (”GST”) tax exemption to an ILIT when the trust is first funded. As a result, the ILIT is a popular form of dynasty trust.

Drawbacks of ILITs

1. Cash Funding: ILITs are typically funded with cash or cash equivalents so that the ILIT can pay large upfront insurance premiums. If an ILIT is funded with an appreciated asset, that asset will likely need to be sold in order to pay the insurance premiums.
2. Irrevocability: When a grantor makes a gift to an ILIT, the gift is irrevocable.
3. Less Liquid: Certain trust types, like SLATs and IDGTs are highly liquid, because the grantor can easily borrow from them. It’s possible for the grantor of an ILIT to borrow from the ILIT as well, but it’s not so simple. The grantor can’t borrow directly against the policy without causing estate-tax problems. The grantor can borrow from the trust itself (as opposed to the policy), but that requires the trust to have assets (perhaps borrowed from the policy) that it can lend to the grantor.
4. No Direct Control: Typically the grantor does not act as trustee of the ILIT, though he or she can remove and replace the trustee at any time.

What is a GRAT?

A GRAT is a type of irrevocable trust that moves assets out of a person’s taxable estate without using that person’s lifetime gift and estate tax exemption. It’s a powerful gift and estate tax strategy. The basic idea is that a person (the “grantor”) transfers an asset to the GRAT and sets an annuity term (usually two years). A portion of the principal is returned to the grantor each year until the end of the term. The exact size of each annuity payment is based on a standardized formula, but basically the grantor is entitled to receive the full amount of the original principal amount plus interest that is based on the government’s interest rate, known as the “7520 rate.” By the end of the term, the original principal (plus some interest) has been returned to the grantor. Any remaining amount in the trust passes to the grantor’s named beneficiaries free of estate tax or gift tax. The GRAT’s magic comes from the ability to transfer wealth to beneficiaries free of tax by simply funding the trust with assets that outperform the 7520 rate. The 7520 rate is equal to roughly 120% of the yield on a 7-Year Treasury Note, so it typically comes out to somewhere in the 3%-5% range. (You can learn more about GRATs here and you can estimate the potential returns here.)

GRAT Example

Imagine that Christine is a New York City resident with a $25 million net worth and a portfolio that generates 9% annual returns (divided equally between capital appreciation and cashflow). If she contributes $6 million to a two-year GRAT when the 7520 rate is 4%, the GRAT will pay her approximately $6.3 million over the course of the first two years. But because the GRAT’s assets are appreciating at 9% while the 7520 rate is only 4%, there will be a remainder left over at the end of Year 2. That remainder — about $500,000 — will pass to Christine’s remainder beneficiary, perhaps a grantor trust for the benefit of her daughter. If Christine decides to set up “Rolling GRATs” — that is, GRATs where the annuity payments are used to fund new GRATs — and she keeps setting up new GRATs each year for 25 years and naming the grantor trust for her daughter as the remainder beneficiary, by Year 25 she will have transferred about $33.1 million to trusts for her daughter, saving her daughter the equivalent of about $14.5 million of tax.

GRATs funded during two-year periods where Christine’s investments performed poorly would fail, but Christine and her daughter would be no worse off than if Christine hadn’t funded the GRAT (aside from the cost of setting up the GRAT).

Note that in this example the GRATs don’t transfer as much wealth as the ILIT described above. But that’s not always the case. If the assumed returns had been higher or more volatile, the GRAT could have easily outperformed.

Benefits of GRATs

1. Estate Tax Savings: The primary advantage of a GRAT is its ability to transfer assets to a grantor’s beneficiaries free of gift tax or estate tax.
2. Ideal for Volatile Assets: Compared to other estate-tax strategies, GRATs are particularly well suited for transferring highly volatile assets. In fact, GRATs thrive on volatility. On average, a GRAT funded with highly volatile assets will generally outperform a GRAT funded with less volatile assets even if the overall percentage growth of the underlying assets is the same.
3. Downside Protection: If GRATs had a motto, it would be “Heads, you win, tails you don’t lose.” A GRAT funded with an asset that drops in value will fail to pass on assets to the beneficiaries, but that failure won’t leave the beneficiaries any worse off than they would have been if the GRAT hadn’t been created. In contrast, with other estate-tax strategies, transferring assets that later drop in value can be tax inefficient.
4. Potential Income-Tax Savings: Although GRATs don’t provide any immediate income-tax savings, they can indirectly save income tax down the line. That’s because a successful GRAT can transfer assets to other taxpayers, who may be in lower tax brackets. When those taxpayers later sell the asset, they’ll pay less tax than the grantor would have paid, due to that lower tax bracket.
5. Relative Liquidity: Compared to many other tax strategies, GRATs have little impact on a grantor’s liquidity. During the term of the GRAT, a portion of the grantor’s assets are in the trust, but the grantor can always borrow from the GRAT without any tax consequences.
6. Direct Control: The grantor can act as trustee of the GRAT during the GRAT term, which means he or she retains direct control over the trust’s assets and how they are invested.

Drawbacks of GRATs

1. GST Inefficiency: A person cannot allocate generation-skipping transfer (”GST”) tax exemption to a GRAT during the annuity period. This makes GRATs less suited to transferring assets to grandchildren or more distant descendants than intentionally defective grantor trusts or other dynasty trusts. Still, GRATs can be a powerful estate-tax strategy alongside other, more GST-efficient strategies.
2. Irrevocability: When a grantor makes a gift to a GRAT, he or she is forfeiting the right to the excess growth above the 7520 rate. That said, if desired, a grantor can prevent too much wealth from being shifted to his or her beneficiaries by “swapping” assets out of the GRAT before the end of the term.
3. Not Ideal for Illiquid Assets: GRATs work very well when funded with liquid assets, but they are often not the best fit for gifts of illiquid assets, like real estate or privately held stock. Illiquid assets in a GRAT will need to be valued at least three different times (upon funding, upon the first anniversary of funding, and upon the second anniversary of funding). The IRS can potentially challenge each valuation. In contrast, liquid assets like public stock don’t need to be appraised at all.

Should You Set Up an ILIT or a GRAT?

ILITs and GRATs both save estate tax, but there are crucial differences between them.

ILITs are generally more tax efficient overall, because ILITs (or the assets they hold) can avoid income tax. They’re also more GST efficient than GRATs. However, taking advantage of the full potential of an ILIT requires acquiring income-producing assets — like private credit — inside of a permanent insurance policy. Some people don’t want to invest in income-producing assets. Others simply don’t trust permanent insurance and would rather pursue non-insurance options. For such people, a GRAT (or other type of trust) funded with some other asset type might be a better fit.

GRATs are ideal for people with volatile assets that are easy to value, like individual stocks or crypto, who are looking to transfer assets to their children. GRATs are particularly useful for people who have limited unused lifetime gift tax exemption, since GRATs don’t require lifetime gift tax exemption in order to work.

It is important to note that there are lots of other gift and estate tax strategies that may make more sense than an ILIT or a GRAT, depending on circumstances. Those strategies are also worth exploring. Moreover, ILITs and GRATs are not mutually exclusive; some people set up both.

Conclusion

ILITs and GRATs are both powerful tax strategies. ILITs make sense for people who are looking to make large gifts and want to maximize their heirs’ tax savings. GRATs make sense for people with volatile assets who are looking to transfer assets to a trust without using any lifetime gift tax exemption.

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