I was recently speaking with a couple from Brentwood recently regarding serious estate tax issues that they were having. This family explained to me that they had been very blessed in their life with a marriage lasting 50 years, three children, and now eight grandchildren. In addition, they told me that they have been very blessed financially as a result of hard work, saving their money, and a little bit of luck. This couple explained to me that their current net worth including all of their assets, bank accounts, and investments was $12.5 million.
However, this family had read some troubling information recently regarding their estate. Specifically, they want to leave a little nest egg behind to their 8 grandchildren and 3 children. However, what they recently heard was that their estate could be taxed at a rate of 40% after their death, and they are extremely worried that a majority of their assets will go to Uncle Sam and not their children and grandchildren.
First, I discussed the current federal estate and gift tax with this couple. I explained to them that when you die, your gross estate is calculated which includes all of the assets that you own at your death. In addition, I explained that the federal government lets you pass up to $5.4 million at death with no estate taxes being owed to the government. However, any amount over this $5.4 million would be subject to the federal estate tax which has a top tax rate at 40%. Although, I also explained to this couple a concept called “portability.” I explained that the government also allows the first spouse to pass away to transfer his or her unused estate tax exemption to the surviving spouse, and that couples that utilizes portability, could create a $10.8 million exemption for the surviving spouse with careful planning.
When I discussed this concept with this family, they were somewhat relieved, but still extremely concerned as this would still create approximately $680,000 in taxes due at their death because they would have $1.7 million over this $10.8 million limit.
I explained that there is a possible solution to their concern about taxes, but it is very complex and it may backfire if they are not careful and do not follow the IRS rules. However, this strategy could be used to reduce their estate taxes and pass assets to their loved ones, and I told them that it is referred to as a Grantor Retainer Annuity Trust (GRAT).
I explained to this couple that a GRAT is an irrevocable trust that we could set up where they would transfer a portion of their assets into this trust for a pre-determined period of time. I continued to explain that what this trust does is that after you transfer a portion of your assets into this trust, the assets would then come back to you periodically in the form of an annuity payment over the years. For example, you could set up a GRAT that has $1,000,000 and that lasts five years with $20,000 to be returned to you every year in the form of an annuity payment. In the meantime, these assets that remain in the trust would continue to accumulate in value in the form of interest or how the assets were invested over years, and at the end of the trust, the income that was accumulated as well as any assets left over in the trust following the final annuity payment back to you, would then be transferred to your children or grandchildren with no gift tax consequences.
I discussed with this family that this could be solution to their concern about estate taxes and could be used as a way to reduce their taxable estate as well as provide a gift to their family. However, I cautioned this couple that if we decide to set up a GRAT, that we must be very careful and pay close attention to the IRS rules on GRATs so that this estate and tax planning strategy accomplishes their goals for their family.