If you have a significant store of wealth, the federal estate tax is something that you should understand when you start to get serious about the process of estate planning. Fortunately, there are solutions, and the grantor retained annuity trust can be one of them when conditions are right. We will explain in this post, but first, we will share the federal estate tax parameters so you can determine if it will impact your estate.
2023 Federal Estate Tax Exclusion
This tax is only a factor for high-net-worth families because there is a credit or exclusion that stands at $12.92 million for the rest of 2023. You can transfer this amount free of taxation, but anything that you transfer that is in excess of the exclusion would potentially be exposed to the estate tax and its 40 percent top rate.
The exclusion was $5.49 million in 2017 before the Tax Cuts and Jobs Act was enacted. It doubled the exclusion with ongoing inflation adjustments. That measure will sunset at the end of 2025, and in 2026, the exclusion is scheduled to revert to the $5.49 million figure indexed for inflation.
There is an unlimited marital estate tax exclusion. This gives you the ability to transfer any amount of property to your spouse tax-free as long as your spouse is an American citizen.
The exclusion has been portable since 2011. In this context, the term “portability” is used to describe the ability of a surviving spouse to use the exclusion that was earmarked for their deceased spouse.
Federal Gift Tax
If you are thinking that you will simply give gifts to your loved ones while you are alive to avoid the estate tax, we have some bad news to pass along. There is a federal gift tax that is in place to close this window of opportunity. The gift tax is unified with the estate tax, and the exclusion is a unified exclusion that applies to lifetime gift-giving along with postmortem asset transfers.
However, there is an additional $17,000 per year, per person exclusion. You are free to give this much to an unlimited number of gift recipients each year without incurring any gift tax liability.
Now that we have shared the necessary introductory information, we can get to the grantor retained annuity trust or GRAT.
This strategy could be effective if you are in possession of highly appreciable assets and interest rates are relatively low. The way that it works is you convey the appreciable assets into the trust, and you decide on the length of the trust term. In so doing, you remove the assets from your taxable estate.
In the trust declaration, you name a beneficiary who would assume ownership of anything that may remain in the trust after the expiration of the term. As the donor, you receive annuity payments from the trust throughout the length of the term.
Gift Tax Implications
Since a beneficiary may be assuming ownership of a remainder, the gift tax is potentially applicable. To account for this, the Internal Revenue Service applies anticipated interest to the value of the trust for gift tax purposes. They apply 120 percent of the federal midterm rate; this is called the Section 7520 rate or hurdle rate.
To gain estate tax efficiency, you want to “zero out” the grantor retained annuity trust. You do this by accepting annuity payments that are going to be equal to the entire taxable value of the trust. Theoretically, at the end of the trust term, there would be nothing left for the beneficiary. The GRAT would be zeroed out.
However, in the real world, assets do not necessarily grow at exactly 120 percent of the federal midterm rate. Obviously, this is especially true when the rate is very low like it was for an extended period of time prior to 2022.
If the appreciation exceeds the amount that was applied by the Internal Revenue Service, there will in fact be a remainder left in the trust after the expiration of the term. The beneficiary would assume ownership of the remainder without incurring any gift tax exposure.
Alternate Tax Efficiency Strategies
This may not be the ideal time to utilize the grantor retained annuity trust in light of interest rates. However, experts expect them to start to stabilize and start to go down in the relatively near future. And remember, this is just one of many tax efficiency tools in the estate planning toolkit.
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