Likely by now you’ve read our 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. The purpose of this article is to directly address the most frequently asked questions about GRATs.
Can I control the GRAT during the term?
Yes, during the two-year GRAT term, you, as the trustee, will have full control over the assets in the GRAT. You’ll set up an account in the name of the GRAT and then buy and sell assets just like you would if the assets were not in a GRAT. The only restriction is that you can’t make distributions from the GRAT to yourself except on the predetermined dates (if you miss an annuity date, you have 105 days to fix your mistake). However, due to the estate and gift tax rules, someone else has to act as trustee when the term ends. Often, people will name a family member (including, potentially, the intended beneficiary) or Valur as the Trustee when the term ends.
Why should an optimized GRAT contain only a single asset?
GRATs succeed when the assets inside of them appreciate at a rate exceeding the 7520 rate. If you fund a GRAT with two assets, there’s a risk that one asset will perform well but the other will perform poorly, cancelling out all or some of the gains generated by the first asset. Obviously, if you had a crystal ball and knew that only one of those stocks would perform well over the subsequent two years, you’d only put the strong-performing stock into the GRAT. But, since you can’t predict which stock will be the winner, it makes sense to create individual GRATs for each of them, so that if one performs strongly and the other struggles, you’ll at least transfer shares in the first stock to your heirs. More broadly, GRATs perform better the higher the volatility of the assets inside them (assuming everything else is equal) and diversification/multiple assets or a longer GRAT term reduces the volatility and lowers the return. To put it more simply, if you have two assets that generate identical returns over the long run but one is more volatile and put them in separate GRATs, the more volatile assets will be more successful and pass on more assets gift and estate tax free to your beneficiaries. The corollary to this is short term GRATs will offer better returns than longer term GRATs even funded with the same exact assets. To better understand it you can read through this article.
Why do shorter GRAT terms make sense?
There are two reasons. The first has to do with GRATs offer higher returns with more volatility (the answer above goes into this and this article explains it in more depth). For this reason, two two-year GRATs will, on average, transfer more to your beneficiaries than one four-year GRAT.
The second reason for choosing short-term GRATs has to do with mortality risk. In order for a GRAT to succeed, the grantor must survive to the end of the term. If the grantor creates a two-year GRAT, there’s a good chance he or she will survive until the end of the term. If the grantor creates a 30-year GRAT, the grantor is more likely to die before the end of the term, which would cause the GRAT to fail. More simply put, you have to have a higher chance of living through a short term GRAT than a long term GRAT! So with a shorter term GRAT you can increase the remainder returns by increasing the assets volatility and reduce your mortality risk at the same time.
What is the “7520 rate” and how does it impact the trust?
The 7520 rate, named after Section 7520 of the Internal Revenue Code, is the IRS’s version of a discount or net present value rate. It varies from month to month, but it is generally about 120% of the 7-year Treasury yield. The 7520 rate pops up in various estate planning contexts, but in the GRAT context, know that it is the hurdle rate that a GRAT has to clear in order to succeed. So, if you fund a two-year GRAT, and the 7520 rate is 4%, the assets in the GRAT will have to appreciate by around 4% or more for the GRAT to succeed and transfer assets to your beneficiaries gift and estate tax free.
What happens if my asset value actually declines?
If you fund a zeroed-out GRAT with an asset that declines in value or appreciates by less than the 7520 rate, the GRAT will fail but there will be no negative consequences to you (aside from the poor investment returns, which would have happened whether the asset was in a GRAT or not). You would end up distributing the entire principal back to yourself while leaving nothing for the beneficiaries. The only downside to setting up a GRAT that fails is that you will be out the transaction costs you spent setting up the GRAT. In this way, GRATs are the ultimate “heads you win, tails you don’t lose” play. (If the GRAT were not “zeroed out,” you would use some gift tax exemption by setting up a failed GRAT. That’s why Valur’s GRATs are virtually always zeroed out.)
What are the rules of increasing payments and how do they work?
GRAT annuity payments are allowed to increase by up to 20% per year. That means that if you set up an a two-year GRAT and the annuity payments are supposed to total $1,000,000, then rather than distributing $500,000 in both Year 1 and Year 2, you can distribute $454,546 to yourself at the end of Year 1 and $545,454 to yourself at the end of Year 2. That way, you keep more of the assets inside the GRAT (in this case, it’s an additional $45,454) until the end of the two-year term, allowing more appreciation to occur inside of the trust rather than in your personal name and increase the amount you pass on to your beneficiaries gift and estate tax free.
How do estate and gift taxes work?
The federal government imposes a 40% estate tax upon individuals’ estates to the extent they exceed the estate tax exemption amount. In 2024, that amount is $13.61 million per person (or $27.22 million for a married couple), though under current law the exemption is set to fall to about $7 million per person (or $14 million for a married couple) on January 1, 2026. The federal government also taxes lifetime gifts above that same exemption amount at a rate of 40%, but there’s no double-dipping: When someone uses a portion of his or her gift tax exemption amount, the donor’s future estate tax exemption is amount is reduced proportionately. So, for example, someone who gifts $5 million to her children during her lifetime will only have $8.61 million of estate tax exemption upon death. And then there are state estate taxes, which can be as high as 20% and often kick in at much lower wealth levels. Oregon, for example, only exempts $1 million of wealth per person from its estate tax.
How are gains taxed?
GRATs are grantor trusts, which means they are disregarded for income tax purposes. As a result, any income tax liability generated by the trust will show up on your income tax return. That’s actually a good thing. If the trust had to pay its own taxes, it would have a harder time clearer the 7520 rate. By paying the trust’s taxes, you’re helping it succeed by leaving more money in the trust to pass on to your beneficiaries gift and estate tax free.
What sorts of assets are best suited for GRATs?
You can put any asset into a GRAT, but some assets are better suited for them than others. The best assets tend to be easy to value and highly volatile. In general, individual securities work very well for GRATs. Someone who had funded a two-year GRAT with Nvidia stock in March 2022 would have transferred well over half of the value of that stock to their beneficiaries, free of gift tax, by March 2024. Cryptocurrency can also work well, though it’s a little bit harder to value. Hard-to-value, less-volatile assets like real estate don’t work as well. There are other, highly efficient ways to transfer real estate to your heirs.
Who can I name as remainder beneficiary?
Most people name their children as their GRAT remainder beneficiaries, but you can also name a sibling, parent, cousin, friend, or non-spousal partner. There are three categories of beneficiaries that should not be named: (1) spouses, (2) grandchildren, and (3) charities. Spouses should not be named as the beneficiaries because you can make unlimited gifts to a spouse without a GRAT; gifts to spouses are not subject to gift tax. Grandchildren are not ideal GRAT beneficiaries because GRATs are not necessarily exempt from generation-skipping transfer tax, so gifts to them may be subject to generation-skipping transfer tax in some cases. Finally, GRATs are not ideal charitable vehicles; if you’re looking to transfer assets to a charity while also benefitting from a GRAT-like structure, you should consider the GRAT’s charitable equivalent, the charitable lead annuity trust or CLAT.
Should I name a trust as remainder beneficiary?
You can name individual remainder beneficiaries or you can name trusts as remainder beneficiaries. Why would you name a trust? There are three major benefits of naming a trust as remainder beneficiary.
First, if your beneficiaries are minors, they are incapable of receiving assets from the GRAT directly, so any remainder that passes to them would have to go to either a trust or a custodial account. For significant amounts of assets, trusts are much better than custodial accounts because they don’t require you to distribute the funds to the child outright when they turn 18 or 21, as most state laws require of custodial accounts.
Second, trusts provide creditor protection. If you name your child as the beneficiary of a trust for his or her benefit, then the child’s creditors (including divorcing spouses) will have a very hard time accessing the assets in the trust. If the assets pass to the beneficiary directly, creditors (including divorcing spouses) will have a much easier time claiming a portion of those assets.
Third, you can use the trust to control distributions to your beneficiaries so that they don’t get the money immediately, or not until they reach a certain age that they haven’t yet reached. That way, you don’t have to worry about the beneficiaries receiving distributions before they’re ready.
Next Steps
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