One of the foundational goals of estate planning is to enable the transfer of assets without losing anything in the process. Why would you lose anything as you attempt to pass along your legacy to your loved ones? It is the federal estate tax that looms large, ready to consume 35% of the taxable portion of your estate, and in New Jersey we have estate and inheritance taxes on the state level as well.
It makes sense to consider giving gifts to reduce the value of your estate in an effort to gain estate tax efficiency. The problem with this is that there is a federal gift tax in place. Though there is a $5 million lifetime exemption the gift tax is unified with the estate tax. So, as a result if you were to give gifts totaling $5 million throughout your life using this exemption the entirety of your estate would be subject to the estate tax.
In spite of this, there are some ways that you can facilitate the transfer of assets to those who would otherwise inherit them while you’re still alive free of the gift tax. One way that this can be done is through the creation of a grantor retained annuity trust, a financial instruments that it is often shortened to the acronym GRAT.
The way that it works is that you fund the trust with assets that you expect to appreciate considerably, and you elucidate a term during which you will receive annual annuity payments from the trust and you name the beneficiary. The funding of the trust is subject to the gift tax, and anticipated appreciation is accounted for through the application of 120% of the federal midterm rate. The tax efficiency strategy involves “zeroing out” the GRAT so you arrange for the annuity payments to be equal to the entire value of the trust. Since you retain all the interest no gift tax is due.
If the assets appreciate beyond the original estimate of the IRS, a remainder will exist once you have received all of your annuity payments and the trust term has ended. Ownership of that remainder is assumed by the beneficiary free of the gift tax.