IDGT vs GRAT: The Comprehensive Review [Example]

In this guide, we will compare the IDGT vs GRAT. These two types of structures are complex and work well in different situations.

Tax-oriented estate planning primarily involves structuring a client’s affairs so as to pass assets to his or her intended beneficiaries — usually members of younger generations such as children and grandchildren — with minimum liability for estate, gift, generation-skipping and income taxes. This is often referred to as wealth transfer planning.

A look at the IDGT

The IDGT (pronounced “I dig it,” which you say when you understand the concept) is a strategy for enhancing the wealth transfer benefits of gifts otherwise made for estate planning purposes.

The IRS has established grantor trust rules. These rules were set up to restrict taxpayers from artificially splitting their taxable income among family members through trusts. Under these rules, if a trust contains specific language, the trust’s income will be taxed to the grantor even though they do not receive it or benefit from it.

With the current lower income tax rate structure, combined with the “kiddie tax” on investment income, there is often little advantage in splitting income within the family. However, the grantor trust rules provide an excellent opportunity for estate planning.

In general, a parent is allowed to place assets in an irrevocable trust for children. The trust language causes it to be “defective” by “flunking” the grantor trust rules. But the good news is that it is still excluded from the grantor’s estate.

While the trust’s income is either retained for the children or paid out to them currently, the IRS mandates that the grantor report all the income on their own 1040 and pay any income tax due. The grantor’s payment of the tax owed on the children’s income is essentially a gift to the children and avoids estate and gift tax.

A look at the GRAT

A GRAT is an irrevocable trust. The grantor transfers assets and then receives a fixed dollar amount (an “annuity”) from the trust for a specified term. When the GRAT term ends, the remaining assets are distributed to the trust’s remainder beneficiaries. 

If the grantor survives the term of the GRAT, the trust assets are excluded from the grantor’s estate. Should the grantor pass away before the end of the period, the trust value is included in the grantor’s estate. 

The goal of the GRAT is to remove any appreciating assets from the grantor estate with the lowest amount of gift tax. As such, a GRAT is an income-producing and estate-freezing strategy that allows a family member to transfer assets to other people with minimal gift tax. It can also potentially avoid estate tax on the property. 

The GRAT requirements include the following:

1. No distributions can be made to anyone other than the holder of the “annuity” during the qualified interest period.
2. The annuity payment must be made at least annually.
3. No annuity prepayment may be made. 
4. Additional contributions cannot be made. 

The asset transfer to the trust is considered a gift. However, the gift tax is limited because the assets are discounted to the present value of the beneficiary’s future right. 

IDGT vs GRAT

As you can see there are pros and cons of the IDGT and the GRAT. They can be structured differently to maximize your situation.