GRAT Planning in a Down Market

September 30, 2011

Authored by: Justin Flach and Doug Stanley

As I walked into the office, I noticed that the market was already down 100 points today.  It’s been doing that a lot lately.  And then it goes back up a little.  And then back down.   While the market is busy doing gymnastics and we’re all concerned about our portfolios and retirement plans, the one thing that shouldn’t get lost in the haze of bad economic news is that now is a great time to do some estate planning.

Setting aside taxable gifts for the moment, let’s focus on a strategy that works best when assets have a built in potential to increase in value and interest rates are low: the grantor retained annuity trust, or a GRAT.

At its most basic level, a GRAT works like this: you give assets to the GRAT at no transfer tax cost and retain the right to receive annuity payments for a term of years.   Any assets left in the GRAT at the end of your retained annuity term pass to the beneficiaries of the GRAT free of gift tax and are removed from your taxable estate.   Your initial gift to the GRAT is not a taxable gift if the value of the annuity payments is equal to the value of the assets you transfer to the GRAT (called a “zeroed-out” GRAT).  If you die during the retained annuity term or if you receive all the assets back in annuity payments, you’re in no worse of a situation than if you’d done nothing.  The trick to a GRAT is that it needs to be funded with assets that are going to appreciate faster than the required annuity payments.

So why does a GRAT make so much sense right now?  For starters, interest rates are incredibly low.   Interest rates (specifically the Section 7520 rate announced by the IRS each month (see here)) are used to determine the amount of your retained annuity payment in a zeroed-out GRAT.   For October, 2011 that rate is 1.40%.  In order for a GRAT to succeed, the assets transferred to the GRAT must grow (through income or appreciation) at a higher rate than the Section 7520 rate.  Now look at the stock market.   The current economic climate has likely created some bargains in your portfolio that can be expected to appreciate over the next several years.

So if you’re looking at the stock market and thinking “based on the current prices, my portfolio is likely to grow by more than 1.4% over the next 2+ years” and you are interested in lowering your estate tax bill, then you ought to be considering a GRAT.