What are Grantor Retained Annuity Trusts?

Have you heard of a grantor retained annuity trust (GRAT)? This type of trust is an efficient way to transfer asset appreciation to beneficiaries without using, or using a minimal amount, of your gift tax exemption.

Here’s how it works: After the donor transfers property to the GRAT and until the expiration of the initial term, the trustee (which is often the donor in the initial term) will pay the donor an annual annuity amount. The annuity amount is calculated using the applicable federal rate as a percentage of the initial fair market value of the property transferred to the GRAT. It is intended to result in a remainder interest (the interest that is considered a gift) valued at zero or as close to zero as possible.

The donor’s retained interest terminates after the initial term, and any appreciation on the assets in excess of the annuity amounts passes to the beneficiaries. In other words, if the transferred assets appreciate at a rate greater than the historic low federal rate, the GRAT will have succeeded in transferring wealth!

Here is an example: Kevin executes a GRAT with a three-year term when the applicable federal rate is 0.8 percent. He funds the trust with $1 million and receives annuity payments of $279,400 at the end of the first year, $335,280 at the end of the second year, and $402,336 at the end of the third year. Assume that during the three-year term, the GRAT invested the $1 million and realized a return on investment of 5 percent, or approximately $95,000.

Over the term of the GRAT, Kevin received a total of $1,017,016 in principal and interest payments and also transferred approximately $95,000 to his beneficiaries with minimal or no impact on his gift tax exemption.