As Benjamin Franklin famously said, “Nothing is certain except death and taxes.” While both are inevitable, smart estate planning can help reduce the tax burden on wealth transfers at death.
Understanding Estate Taxes and Exemptions
Current estate tax laws allow individuals to gift or pass down up to approximately $14 million without incurring federal estate taxes. However, this threshold is subject to change. Less than a decade ago, the “lifetime exemption amount” was around $5.5 million. Any wealth transferred above the exemption is taxed at a steep 40% rate, making proactive estate planning essential for high-net-worth families.
One effective estate planning strategy that we can implement to benefit our clients is a Grantor Retained Annuity Trust (GRAT), which allows assets to be passed on to heirs with minimal estate and gift tax consequences. This approach can be particularly valuable for those whose net worth is near or above the exemption threshold.
Basic Gifting vs. GRAT Strategy
For families whose net worth is close to the exemption amount, a simple strategy involves using the annual gift tax exclusion, which allows individuals to gift up to $19,000 per recipient in 2025 without reducing their lifetime exemption. Gifting removes assets from your estate, and any future growth of those assets occurs outside your taxable estate.
A GRAT takes this concept a step further. It provides a way to transfer significantly more wealth while minimizing estate tax liability. While a GRAT involves more complexity and legal costs, it can yield substantial benefits relative to utilizing the annual gift tax exclusion.
How a GRAT Works
A GRAT is an irrevocable trust funded by the grantor (the person creating the trust). It is effectively a super-charged version of the annual gift tax exclusion with the potential to transfer substantially more assets outside of your estate. There are many ways that a GRAT can be structured, but one common method is what some professionals refer to as a “2-year zeroed-out” strategy. This approach refers to a GRAT with a two-year term where the grantor funds a trust and in exchange receives payments over the next two years of principal and interest at an IRS-specified interest rate (known as the Section 7520 rate).
As a result of the GRAT making payments using the Section 7520 interest rate, the amount that the grantor transfers to the GRAT does not count towards their lifetime exemption amount. In this way, utilizing a “zeroed-out” GRAT is similar to the annual gift tax exclusion strategy. If the investments inside the GRAT grow at a rate higher than this IRS rate, the remaining assets pass to the grantor’s beneficiaries tax-free at the end of the GRAT term. If the investments underperform, all assets return to the grantor, and no wealth transfer occurs.
Example: A 2-Year “Zeroed-Out” GRAT
Consider a family with a $40 million net worth looking to reduce their future estate tax burden. After consulting with their estate attorney and financial advisor, they decide to transfer $10 million of their stock portfolio into a 2-year GRAT.
Using a recent IRS Section 7520 rate of 5.2%, the GRAT makes two payments back to the grantor:
- Year 1 Payment: $4.9 million
- Year 2 Payment: $5.9 million
If the portfolio earns an 8% return in both years of the GRAT’s term, the GRAT will still have approximately $472,000 left at the end of the two-year term. This remaining amount transfers to the grantor’s beneficiaries (typically children or a trust for their benefit) without any estate or gift tax.
By removing $472,000 from their taxable estate, the family avoids paying a potential $188,800 in estate taxes (assuming a 40% tax rate). Additionally, any future growth of that $472,000 happens outside the grantor’s estate, further reducing future estate tax exposure.
What Happens If the GRAT Underperforms?
If the growth of the GRAT’s investments is less than the IRS-specified rate, the trust simply returns the assets to the grantor without transferring anything to the beneficiaries. In this instance, the only disadvantage is the administrative costs of setting up the GRAT, but the potential upside is often worth the administrative costs.
Is a GRAT Right for You?
While GRATs involve some complexity and administrative costs, they remain a powerful tool for high-net-worth individuals looking to reduce estate taxes and transfer wealth efficiently. With thoughtful planning and favorable market conditions, a well-structured GRAT can provide substantial tax savings while ensuring more assets pass to future generations.
Given the ever-changing tax laws, it’s essential to work closely with an estate planning attorney, accountant, and financial advisor to determine whether a GRAT aligns with your broader financial goals.
