Grantor Retained Annuity Trusts (GRATs) allow clients the ability to move a large amount of assets outside of the estate so that part of the future appreciation of the assets is outside of the estate. However, GRATs come with a few key trade-offs. The first tradeoff is that instead of allowing assets in the GRAT to earn compound interest indefinitely, assets in the GRAT often have to be sold every year in order to make payments back to the grantor. This creates tax-drag on wealth creation. The second tradeoff is that all assets in the trust lose step-up in basis at death of the grantor that would be available if invested within the estate. So if the GRAT is used to invest in long-term buy and hold assets, the client’s beneficiaries would have a large income tax liability at the time the assets are transferred to the beneficiaries. In states with high-income tax-rates, clients could be setting up GRATs to avoid the estate tax only to have their beneficiaries pay income taxes on the gains at almost the same rate. In many cases this means that a GRAT often imposes more harm than benefit to the client. Protecting the client from an estate tax liability only to expose them to a larger tax-drag and income tax liability, can pose more harm than good. The best way to maximize the value of a GRAT is to utilize the GRAT for assets that are tax-inefficient—while investing in assets that are tax-efficient from inside the estate so that these assets can benefit from tax-free compounding through step-up in basis. Therefore, in order to maximize the value of the GRAT it should be implemented as part of a holistic estate, investment, and wealth management plan.

“Protecting the client from an estate tax liability only to expose them to a larger tax-drag and income tax liability, can pose more harm than good”

THE DOWNSIDES OF GRANTOR ANNUITY TRUSTS

Grantor Retained Annuity Trusts (GRATs) offer a good way to move part of the future appreciation of assets outside of the estate. However, there are a number of downsides of using a GRAT:

• In order to make GRAT annuity payments back to the grantor, the GRAT must either have realized gains or sell assets in order to make the payment.
  Assets within the GRAT often need to be sold in order to make required annuity payments back to the grantor. This tax-drag reduces long-term returns as opposed to just compounding returns for the long-term on a tax-deferred basis. While the GRAT could make in-kind payments back to the grantor in order to meet the required annuity payments, this would subject the capital appreciation of the assets to the estate tax—which defeats the purpose of establishing the GRAT in the first place. This is another reason why it’s important to utilize tax-inefficient assets within the GRAT as those assets would have annual realized gains that can’t be deferred whether they are inside or outside of the GRAT.
• All assets within a GRAT lose the benefit of step-up in basis and are exposed to income taxes.
  While a GRAT helps assets avoid the estate tax, the assets in the GRAT lose the benefit of step-up in-basis which can expose the assets in the GRAT to state and federal income tax that they otherwise wouldn’t be exposed to. This means that the benefits of avoiding the estate tax are minimized since the beneficiaries would still having to pay full federal income and state tax on any unrealized gains that they might otherwise be protected from. Utilizing a GRAT essentially means replacing an estate tax liability with an income tax liability. This is particularly a problem for clients that live in states with high income taxes (eg CA, NY, NJ, etc). Therefore, it’s important to consider the income tax consequences of both the grantor and beneficiary when analyzing whether the GRAT would be beneficial to the client.
• Tax-inefficient assets are the better fits for GRATs than tax-efficient assets.
  Tax-efficient assets allow for taxes to be deferred until they are sold which allows for the benefit of compound interest as well as the step-up in basis provision. Placing tax-efficient assets within a GRAT causes these assets to lose these benefits. Tax-inefficient assets, on the other hand, are assets that don’t allow for this type of tax-deferral as gains are realized on an annual basis and can’t be deferred. Furthermore, these assets are often taxed at a higher rate than tax-efficient assets. Placing tax-inefficient assets within a GRAT allows these assets the ability to achieve greater tax-deferral benefits than would be possible if these assets were outside of the GRAT.
• GRAT annuity payments introduce income back to the grantor which IS included in the estate.
  While a GRAT helps get capital appreciation above the hurdle rate outside of the estate, the original value of the GRAT plus interest up to the hurdle rate must be returned back to the grantor’s estate. Furthermore, if this amount is reinvested and grows so will the value of the estate and the estate taxes owed in the future.
• If there are realized gains in the GRAT, all the taxation flows down to the grantor or the beneficiary.
  All realized gains within the GRAT flow down to the grantor (or the beneficiary if a distribution is made). In order to maximize the value of the GRAT, clients need to ensure that they have enough assets outside of the GRAT to pay these taxes.
• In a high-interest rate environment, the benefits of using a GRAT are minimized.
  A GRAT benefits from the earned rate the assets earn versus the interest rate owed back to the grantor. So a clear benefit here is the difference between the rate the assets earn and the interest rate owed back to the grantor. In a high interest rate environment, this benefit is minimized.
• If the grantor dies during the term of the GRAT, all the assets remaining within the GRAT at the time of death are included in the estate thereby minimizing the value of the GRAT.
  Since the main benefit of the GRAT is to benefit from the difference between the earned rate of the assets and the interest rate owed to the grantor, ideally you want to maximize the term of the GRAT in order to maximize the compounding effect of the difference in interest rates. However, the downside with this is that if you set the GRAT term for too long and the grantor dies, the remaining assets in the GRAT are subject to the estate tax.

Table 1: Benefits and Disadvantages of Investing via a Taxable Account vs a GRAT

Estate Planning Tool	Assets Outside of the Estate?	Returns Protected from Estate Tax?	Long-Term Returns Protected From Income Tax through Step-Up in Basis?	Minimizes Tax-Drag?	Ability to Take Loans for Liquidity?
Taxable Account (No GRAT)			x	x	x
GRAT	x	x			x

While a GRAT allows part of the future appreciation of the assets from estate tax, it exposes these assets to income tax that could otherwise be passed on tax-free via step-up in basis while exposing these assets to additional tax-drag. Therefore, it’s important to evaluate what type of assets are a best fit for the GRAT.

BASE GRAT EXAMPLE
To understand the benefits and downsides of a GRAT, it’s helpful to use a case example.

Example 1:
John and Mary are both 60 and live in California and plan on staying there for the rest of their life. They are currently considering moving $50M outside of their estate (those assets have a $30M cost basis). John and Mary already have a high income and therefore don’t need any income from the $50M. Their goal is to pass this $50M so that their kids can sell the assets when they die in the most efficient way possible. They are considering either keeping this money in their estate or using a Zeroed-Out GRAT to minimize the estate taxes owed. John and Mary’s marginal tax rate for capital gains is 37.1% (20% federal tax-rate, plus 3.8% net investment income tax, plus 13.3% state tax rate). The estate tax in 2023 is currently 40% above $25.84 million. Their $50M is primarily invested in low cost S&P 500 and other equity index funds and they would like to keep that allocation whether it is in the GRAT or outside the GRAT.

John and Mary are wondering whether it is better to keep the assets in their estate and pay estate tax-rate (40%) or whether to move the money out of their estate and have their beneficiaries pay the full 37.1% capital gains tax-rate on the gains when they die.

Here are the assumptions used in the analysis:

• John and Mary live 30 years and then die. Upon their death, all assets are sold with their beneficiaries receiving the after-tax proceeds.
• Primary asset allocation are low-cost, tax-efficient, equity index funds.
• Asset appreciation rate of 8%.
• $50 million fair market value of assets with $30 million in cost-basis.
• In the GRAT analysis this $50M is transferred to the GRAT using the full $25.8M gift exemption and a zeroed out GRAT amount for the remaining $24.2M. A 30 year GRAT is used with a level annuity for simplicity, although in reality shorter-term rolling GRATs would be used (often with a graduated annuity).
• 120% AFR rate (hurdle) of 4.4%.
• Estate Tax Rate of 40%
• Total Long-Term Capital Gains Rate of 37.1%.

Table 2: Investing Tax-Efficient Assets Without a GRAT vs With a GRAT

	Inside of Estate Assets at Death			Outside of Estate Assets at Death			Total After-Tax Wealth at Death
	Market Value of Assets Before Estate Tax ($M) (A)	Estate Tax Owed ($M) (B)	Inside of Estate After-Tax Wealth at Death ($M) (C=A+B)	Outside of Estate Assets Before Income Tax ($M) (D)	Income Tax Owed ($M) (E)	Outside of Estate After-Tax Wealth at Death ($M) (F=D+E)	Total After-Tax Wealth at Death (G=C+F)	Total After-Tax IRR (H)
No GRAT	$503	($191)	$312	$0	$0	$0	$312	6.30%
With GRAT	$104	($42)	$63	$337	($114)	$223	$286	5.98%

With a tax-efficient asset like an S&P 500 index fund, a GRAT helps reduce estate taxes on in-estate assets, but also helps create income tax liabilities on outside of the estate assets which reduces the after-tax value of out-of-estate assets. For residents in states with high income taxes, this mitigates the value of a GRAT in the first place since federal and income taxes in states can be nearly as high as the estate tax-rate itself. Furthermore, the tax-drag of having to make the annuity payments prevents the out-of-estate assets from compounding at the same rate they would be able to if they were in the estate.

The above table shows the impact of using a GRAT on inside of the estate wealth (Columns A through C), outside of the estate wealth (Columns D through F), and cumulative after-tax wealth(Columns G and H) which summarizes the total after-tax impact of using the GRAT vs not using the GRAT.

The above table shows that if John and Mary wish to invest in a tax-efficient asset like an S&P 500 index fund, they would be better off doing so without using a GRAT. While the GRAT helps reduce estate taxes on inside the estate assets (from $191M to $42M as shown in Column B), it also introduces tax-drag and income tax-liabilities on outside of the estate assets (from $0 of income tax liabilities to $114M as shown in Column E).

The net effect here is that John and Mary would have $26M more at death ($312M vs $286M as shown in Column G) from keeping the assets in the estate and not using a GRAT vs using a GRAT. We can see that the difference in after-tax IRRs is also 0.32% (6.30% vs 5.98% as shown in Column H).

Choosing to avoid a 40% estate tax only to open the client up to a 37.1% income tax rate liability is not much of a benefit here. Especially when the drag of annuity payments are taken into consideration. It’s better to just let the assets compound inside of the estate and pay the estate tax than to implement the GRAT strategy.

UNDERSTANDING THE IMPACT OF TAX-DRAG

To understand why tax-drag can be so detrimental it’s helpful to look at another example.

Example 2:
John and Mary have the choice of investing $1M in two different assets for 30 years. Both assets earn 8% and are taxed at 50%. However Asset A allows for the tax to be paid at the end of the 30 years, while Asset B requires that the 50% tax is paid every year on the gains. Which asset should John and Mary invest in?

Table 3: Performance of Tax-Efficient vs Tax-Inefficient Assets with an 8% expected pre-tax return

	After tax value at the end of 30 years	After-Tax IRR
Asset A (Tax at the end of 30 years/Tax-Efficient)	$5,531,328	5.9%
Asset B (Yearly Tax/ Tax-Inefficient)	$3,243,398	4.0%

By investing in tax-efficient Asset A instead of tax-inefficient Asset B, John and Mary can create almost $2.3M more in after-tax wealth.

As the above table shows, getting taxed 50% at the end of 30 years instead of at the end of each year can lead to 70% more after-tax wealth ($5.5M vs $3.2M). The effect of the annual tax-drag and the reduction in compounding can create a significant impact on the returns of the client. This is why having to liquidate assets within the GRAT on a yearly basis to make GRAT payments back to the grantor can have such a large impact on the difference in returns between using GRATs vs not using GRATs.

Generally tax-efficient assets are best kept within the estate. Only states that have no state income tax can benefit from placing tax-efficient assets within a GRAT. And even then the benefit is small as the table below shows.

Table 4: Impact of no-state taxation on capital gains with tax-efficient assets

	Inside of Estate Assets at Death			Outside of Estate Assets at Death			Total After-Tax Wealth at Death
	Market Value of Assets Before Estate Tax ($M) (A)	Estate Tax Owed ($M) (B)	Inside of Estate After-Tax Wealth at Death ($M) (C=A+B)	Outside of Estate Assets Before Income Tax ($M) (D)	Income Tax Owed ($M) (E)	Outside of Estate After-Tax Wealth at Death ($M) (F=D+E)	Total After-Tax Wealth at Death (G=C+F)	Total After-Tax IRR (H)
No GRAT	$503	($191)	$312	$0	$0	$0	$312	6.30%
With GRAT	$127	($51)	$76	$337	($73)	$264	$340	6.60%

Removing the 13.3% California state income tax helps reduce the total income tax liability on outside the estate assets from a 37.1% rate to a 23.8% rate.  In this case, the GRAT adds $28M of extra after-tax wealth and increases the after-tax IRR from 6.30% to 6.60%

The above table shows the impact of using a GRAT on inside of the estate wealth (Columns A through C), outside of the estate wealth (Columns D through F), and cumulative after-tax wealth (Columns G and H) which summarizes the total after-tax impact of using the GRAT vs not using the GRAT.

Removing the hefty California state income tax from the equation does help the GRAT to provide more value. In fact, doing so helps increase the after-tax wealth by $28M from $312M to $340M (Column G). However, this is only a 9% increase which is why the IRR only goes up 30 basis points from 6.3% to 6.6% (Column H). So even when removing the state income tax from the equation, the value add of the GRAT is still fairly small if the client is considering investing in long-term, tax-efficient assets.

THE VALUE OF GRATS IS MAXIMIZED WHEN USING TAX-INEFFICIENT ASSETS

As evidenced in the previous section, if the client wishes to invest in long-term, tax-efficient assets like S&P 500 index funds, then the client is often better off investing in those assets from within the estate than within a GRAT. This is especially true if the client lives in states with high income tax rates.

However, the value proposition of using GRATs is significantly higher if the client wants to invest in tax-inefficient assets like hedge funds, commodities, or short-term trading strategies. The reason for this is that these assets often realize gains on an annual basis thereby creating a lot of tax-drag on the returns. So placing these types of assets within a GRAT that is already income tax-inefficient makes more sense than investing in tax-efficient assets through the vehicle. Furthermore, most tax-inefficient assets are taxed at higher rates than tax-efficient assets thereby making the value proposition even better.

The value of using tax-inefficient assets instead of tax-efficient assets in GRATs can be seen in the table below where the income tax rate is still the same at 37.1% but is taxed on an annual basis instead of on a deferred basis.

Table 5: Investing in Tax-Inefficient Assets Outside of a GRAT vs Inside a GRAT

	Inside of Estate Assets at Death			Outside of Estate Assets at Death			Total After-Tax Wealth at Death
	Market Value of Assets Before Estate Tax ($M) (A)	Estate Tax Owed ($M) (B)	Inside of Estate After-Tax Wealth at Death ($M) (C=A+B)	Outside of Estate Assets Before Income Tax ($M) (D)	Income Tax Owed ($M) (E)	Outside of Estate After-Tax Wealth at Death ($M) (F=D+E)	Total After-Tax Wealth at Death (G=C+F)	Total After-Tax IRR (H)
No GRAT	$218	($77)	$141	$0	$0	$0	$141	3.52%
With GRAT	($79)	$0	($79)	$337	($7)	$330	$251	5.52%

Investing in tax-inefficient assets within a GRAT has significantly higher benefits than investing in those same assets outside of the GRAT. In this case, using the GRAT to invest in these assets increases the IRR by 57% (from 3.52% to 5.52%).

The above table shows the impact of using a GRAT on inside of the estate wealth (Columns A through C), outside of the estate wealth (Columns D through F), and cumulative after-tax wealth(Columns G and H) which summarizes the total after-tax impact of using the GRAT vs not using the GRAT.

As Column G shows, investing in tax-inefficient assets within a GRAT results in a significant increase in wealth ($251M) vs investing in those same assets outside of the GRAT ($141M) which results in a 5.52% after-tax IRR using the GRAT vs a 3.52% after-tax IRR outside of the GRAT (Column H).

The key reason for this is that heavy taxation of the tax-inefficient assets would occur whether the assets were inside the GRAT or outside. In other words, there is no extra tax-drag being generated by using the GRAT when you use tax-inefficient assets. In fact, the active taxation of the assets makes the value of the GRAT higher since the GRAT allows tax-deferred compounding that would not be available outside the GRAT. This is why using the GRAT in the above example allows for significantly higher wealth than not using the GRAT.

The same cannot be said with tax-efficient assets. Tax-efficient assets allow for tax-free compounding until the assets are sold. As we saw in Example 2, the impact of this tax-free compounding is large. This is why we saw in Table 1 that using the GRAT with tax-efficient assets was actually worse than not using a GRAT.

The above table also reveals another consequence of tax-drag that is often neglected in the GRAT planning process—namely that the Grantor is responsible for paying taxes on the gains so that the GRAT assets can compound on a tax-deferred basis. In the above example, the amount of taxes owed on the annual gains of the GRAT is higher than the annuity payment being paid to the grantor. This is why in the GRAT strategy above there is a $79 million liability that the grantor has to pay in excess of the annuity payments from inside the estate. In other words, the grantor will have to sell assets that are inside of the estate in order to pay the taxes which might create a liquidity problem for the grantor. This is why it’s important that the income tax consequences of the GRAT be taken into effect instead of purely focusing on the estate tax benefits.

TAXATION OF ASSETS HAS MORE OF AN IMPACT THAN INTEREST RATES
When it comes to GRATs, it’s often assumed that the most important factor here is the difference between the GRAT’s earned rate (the rate the assets are appreciating in the GRAT) and the hurdle rate (the rate of interest that has to be paid back to the grantor).

However, as shown in the table below changing the hurdle rate doesn’t improve the value of using a GRAT nearly as much as the tax-efficiency of the assets being invested in.

Table 6: Investing in Tax-Inefficient Assets Outside of a GRAT vs Inside a GRAT

The biggest value add of a GRAT comes when the underlying assets are tax-inefficient. As seen above, using tax-inefficient assets helps improve the after-tax IRR of the underlying assets by 56.9%. Furthermore, even if the hurdle rate is 0% it is still better to invest tax-efficient assets outside of a GRAT than inside of a GRAT if the client lives in a state with a high state income tax.

	After-Tax IRR using No GRAT	After-Tax IRR With GRAT	% IRR Improvement through GRAT
Base Case with Tax-Efficient Assets	6.30%	5.98%	-5.0%
Base Case with Tax-Inefficient Assets	3.52%	5.52%	56.9%
Base Case with No State Income Taxation	6.30%	6.60%	4.8%
Base Case with 0% Hurdle Rate	6.30%	6.21%	-1.4%
Base Case with 8% Hurdle Rate	6.30%	5.74%	-8.9%

The table above shows that when clients live in a state with a high income tax, utilizing a GRAT has the maximum benefit when the client is investing in tax-inefficient assets. If the client is investing in tax-efficient assets, then even if the hurdle rate is 0% the client is still better off investing in those outside of the GRAT than within it.

While this may seem counterintuitive, we have to understand the effect of lowering or increasing the hurdle rate. Lowering the hurdle rate means that less payments have to be made to the grantor which means that less assets are subject to the estate tax. However, since less assets are paid to the grantor, then more wealth accumulates within the GRAT and those assets are subject to state and federal income tax.  The opposite is true if the hurdle rate is high; more payments are made to the grantor so estate taxes are higher, but there is less wealth accumulation within the GRAT so income taxes are lower. In other words, the fact that estate taxes and income taxes work as opposing levers here means that there is a large buffer created with regards to the hurdle rate. Whether the hurdle rate is high or low doesn’t have nearly as much of an impact as whether the assets being invested are tax-efficient or tax-inefficient.

THE IMPORTANCE OF HOLISTIC ESTATE AND INVESTMENT PLANNING

As this article shows, implementing a GRAT as part of an estate planning solution doesn’t always make sense for the client—especially if the client plans on investing in tax-efficient assets and lives in a state with high income taxes.

In order to implement a GRAT strategy that is in the best interests of the client, a more holistic approach needs to be taken that considers the impact of the strategy from an estate, investment, and wealth management perspective. Only evaluating the GRAT strategy from an estate planning perspective runs the risk of incurring heavy state and income tax liabilities that would negate the estate planning benefits.

In order to create a strategy that is in the best interests of the client, a review of the client’s investment portfolio and strategies must be taken into account so that the client’s most tax-inefficient assets can be placed in the GRAT while the tax-efficient assets are kept within the estate in order to benefit from step-up in basis.

DISCLAIMER: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

About the Author
Rajiv Rebello, FSA, CERA is the Principal and Chief Actuary of Colva Actuarial Services and Colva Capital. Colva helps estate attorneys, family offices, and RIAs create better after-tax and risk-adjusted portfolio solutions for their UHNW clients through the use of life insurance vehicles and low-correlation alternative assets. He can be reached at rajiv.rebello@colvaservices.com.