Michael Matisse of Radnor Financial.

The Tax Cuts and Jobs Act (TCJA) of 2017 increased the lifetime estate/gift exemption. Given the annual inflation adjustment, the limit increased to $11,580,000 in 2020. However, the increased limit sunsets after 2025 and reverts back to the prior level, likely around $6.5 million per person at that time. Assets above those amounts are subject to a 40% estate/gift tax.

For individuals with large estates (or those concerned that the exemption amounts may decrease even further), they may wish to consider utilizing a grantor retained annuity trust (GRAT). GRATs can be a useful tool for passing money between generations while potentially avoiding estate and gift taxes.

Under a GRAT, the grantor transfers assets to a trust and retains the right to receive a fixed annuity for a term of years. At the end of the term, to the extent that the trust has earned more than the required distributions, the remaining or "excess" assets in the GRAT pass to the trust beneficiary free of gift/estate tax.

The required distributions are basically the principal contributed to the GRAT plus interest. The IRS uses Section 7520 rates as the required interest rate to calculate the GRAT annuity distributions. If the assets increase by more than the required interest rate, the "excess" value will pass to the GRAT beneficiary without incurring estate or gift tax. Currently, the Section 7520 rate is low (2% range).

The key benefit of a GRAT is the ability to remove the appreciation in value of an asset(s) from the grantor's estate while using almost no estate and gift tax exemption or payment of gift tax. While the gift to the GRAT is a taxable event, the gift tax cost should be zero, as it is computed on the value of the remainder interest at the time of the transfer of assets into the GRAT. The value of the remainder interest is computed by taking the original value of the transferred property and subtracting the present value of the annuity payments. Assuming the annuity value approximates the value of the assets transferred into the trust, the gift tax cost is zero.

The disadvantage of GRATs occur when the assets in the GRAT don't appreciate by more than the Section 7520 rate. If the GRAT doesn't earn a rate of return in excess of the Section 7520 rate, all of the assets will be returned to the grantor, with no "excess" value to the beneficiaries. The downside to the grantor is the administrative cost and fees associated with establishing and maintaining the GRAT. Similarly, if the grantor dies before the end of the GRAT term, the estate will be in no worse situation than if the transfer never occurred, except for the administrative costs and fees of establishing and maintaining the GRAT.

In practice, we have been proponents of employing a series of two-year GRATs. By creating a series of short-term GRATs, you are able to get monies to the beneficiaries sooner, are only a year away from getting half of the assets back, and a bad year in the markets has less of a long-term impact (although it likely means that GRAT will be unsuccessful, you will be regularly creating new GRATs).

The next time you talk with your estate planning attorney (or financial adviser), ask if they think a GRAT may be appropriate for you. Executed properly, GRATs can be a very effective way to transfer assets without incurring estate/gift taxes.

Michael N. Mattise has been with Radnor Financial Advisors since 1988 and serves on the firm's board of managers. As a senior consultant, Mattise assists in the management of clients' investment assets and handling their financial planning. As CIO, he is responsible for the firm's investment manager review process and oversight of its portfolio management system.