So you’re not familiar with grantor retained annuity trusts, better known as GRATs? That may not be a bad thing, given that this particular speculative estate planning tool has a questionable future — at least as it currently exists. In any case, financial advisors who steer clients towards GRATs should do so with a cautious eye, and only with clients that hold the appropriate levels of assets.

How They Work

In a nutshell, GRATs are irrevocable trusts that let wealthy individuals (grantors) shift substantial sums of money to family members, while bypassing traditional federal estate and gift tax liabilities, both which currently stand at 40%. And as the name suggests, the grantor, typically a family patriarch, retains the right to collect annual annuity payments for a certain number of years, then any remaining assets in the GRAT are distributed to beneficiaries of the grantor’s choice. (For more, see: Estate Planning Tips for Financial Advisors.)

But in order for GRATs to succeed, the underlying investments must outperform a hurdle known as the “7520 interest rate” — a figure declared at the time of the trust’s launch. Calculated monthly by the Internal Revenue Service, the 7520 rate is linked to the auction of 3-to-9 year Treasury notes. In November 2015, for example, the 7520 rate was 2%. Therefore, if a patriarch has a portfolio of high-yield bonds paying 7%, the difference between their eventual return and the 7520 figure would be 5% - a net profit pocketed by next generational family members tax free. And with today’s 7520 figure at near historic lows, GRATs are an attractive transfer vehicle of late. But that could change if the 7520 rate rises, like when it hit a historic high of nearly 12% in 1989. For this reason, financial advisors are encouraging wealthy clients to lock in GRATs sooner than later, before the pendulum swings back the other way.

But 7520 aside, obviously any stock or fund investment can tank below that 2% threshold, leaving the next generation with nothing. For this reason, wealthy individuals often diversify their holdings across multiple GRATs, to make sure the reliable winners aren’t dragged down by more speculative investments. (For more, see: Tips for Handling Client Inheritance.)

Calculating the Annuity

It is preferable to express the amount of the annuity, which may be paid monthly, quarterly or semiannually, as a fixed percentage of the property in the trust. Regulations allow for the amount of the annuity payment to increase over the term of the GRAT, but not in excess of 120% of the amount paid in the previous year. The annuity payment is either based on the taxable year of the GRAT or of the GRAT’s anniversary date. If it’s the latter, payment must be paid within 105 days after the trust’s launch date anniversary.

Going the Distance

GRATs demand an important consideration. Only healthy would-be grantors should take the plunge, because grantors must live out the terms of the GRAT in order for the vehicle to work. If the grantor dies before the GRAT matures, the wealth transfer initiative goes up in smoke. (For more, see: Top Tips for Helping Clients Leave an Inheritance.)

Currently, governmental regulations hold GRATs to a two-year minimum. Consequently, grantors often set up a series of rolling two-year GRATs to get around this law. But a change may be underway. Due to efforts by the Obama administration to boost tax revenue for the country, various budget proposals have aimed to minimize the efficacy of GRATs as estate reduction tools, by augmenting their current two-year minimum to 10 years. This would increase the likelihood of grantors dying during the life of the trusts, consequently pulling assets back into their taxable estates. Additionally, the Obama administration proposes eliminating “zeroed-out” GRATs. This refers to GRATs where the grantor’s retained interest is valued identically with the market value of assets transferred to the trust. And their projected growth is dictated by 7520, thereby reducing the taxable gift to almost zero. (For more, see: What Advisors Can Learn From Ultra-Wealthy Clients.)

The Bottom Line

With 7520 interest rates currently near their historic lows the hurdles GRATs must clear for beneficiaries to collect their cash are presently favorable, making this instrument an attractive method of intergenerational money transfer. But even under the best of circumstances, GRATs aren’t for everyone. This is because other than a retained annuity, parking assets in a GRAT means irrevocably ceding control over them. This means only people with a critical net worth should consider this method of gifting assets to the next generation. And with possible regulatory changes, coupled with the looming potential of increasing 7520 interest rates, the advantages of GRATs may dip, so the window for their optimal use may decline. (For more, see: see: A Quick Guide to High-Net-Worth Estate Planning.)

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