One of the things you have to be aware of when you are planning your estate is the threat of asset erosion due to the estate tax. Some people assume that they can simply give away their assets as gifts before they pass away to avoid the estate tax, but there is a gift tax in place with a rate that mirrors the estate tax. There is a $5 million gift tax exemption, but because the gift and the estate taxes are unified the exemption is unified. As a result, if you used your $5 million exemption giving tax-free gifts all of your estate would be subject to the estate tax.
So you have to employ tax efficiency strategies wherever possible, and one of these would be the “zeroed out” GRAT strategy. GRAT is the acronym that stands for grantor retained annuity trust, and with these vehicles you receive ongoing annuity payments for a period of time that you specify upon creation of the trust. You name a beneficiary who would assume ownership of any remainder that may exist.
The initial act of funding the trust constitutes a taxable gift, and the IRS will account for anticipated interest using 120% of the federal mid-term rate. But, its taxable value will be reduced by your retained interest. The objective here is to zero out the GRAT, so you arrange for your annuity payments to equal the entire value of the trust.
When funding the trust you want to use securities that you would expect to appreciate significantly over the term of the trust. If the securities earn more than the original IRS estimate using 120% of the mid-term rate, there will be a remainder when the trust term expires. This remainder will be transferred to your beneficiary and it will not be subject to the gift tax.