How a Grantor Retained Annuity Trust Works

A Grantor Retained Annuity Trust lets you transfer money to family members while receiving income payments for a set period

A Grantor Retained Annuity Trust (GRAT) is a legal structure where you put money or assets into a trust, receive fixed payments back for a number of years you choose, and then whatever remains passes to your beneficiaries — usually family members — tax-free or with reduced taxes. You are the grantor (the person who creates it), and you keep the right to receive annuity payments during the trust's term. After that term ends, the remaining assets go to whoever you named as beneficiaries.

The main reason people use a GRAT is to move wealth to the next generation while paying less in gift and estate taxes. The IRS allows this because you are giving up the assets eventually, and the value of that gift is reduced by the annuity payments you receive back. If the assets inside the GRAT grow faster than the IRS interest rate used to calculate the trust, your beneficiaries receive that extra growth without triggering gift tax.

Key Takeaways

• You fund a GRAT with cash or assets, receive fixed annuity payments for a term you set (often two to ten years), and the remainder passes to beneficiaries when the term ends.
• The IRS uses a specific interest rate (the Section 7520 rate) to calculate how much of your gift is taxable; if your assets grow faster than that rate, the excess passes to beneficiaries tax-free.
• A GRAT works best with assets you expect to grow significantly, because the growth above the IRS rate is the part that avoids gift tax.
• You must survive the entire trust term for the tax benefits to work; if you die before the term ends, the remaining assets return to your estate and may be taxed.
• Setting up a GRAT requires an attorney and a trustee, and you will need to file tax returns for the trust each year it exists.

How the IRS interest rate affects what you owe in taxes

The IRS publishes a monthly interest rate called the Section 7520 rate, which is used to value the annuity payments you will receive from the GRAT. This rate changes based on current Treasury yields. When you create the GRAT, the IRS assumes your assets will grow at that rate. If they grow faster, the extra growth is a gift to your beneficiaries — but because the IRS already "accounted for" growth at the Section 7520 rate, that extra growth is not subject to gift tax.

For example, if the Section 7520 rate is 4% and you put $1 million into a two-year GRAT, the IRS calculates that you will receive annuity payments worth a certain amount, and the remainder is valued as a gift. If your $1 million grows to $1.2 million instead (because the assets performed better than 4%), that extra $200,000 passes to your beneficiaries without using any of your lifetime gift tax exemption. This is why GRATs are most useful when you expect strong growth.

Who should consider a GRAT and when

A GRAT makes sense if you have assets you believe will grow significantly — stocks, real estate, a business interest, or a portfolio of investments. It is less useful for stable, low-growth assets like bonds or savings accounts, because the benefit depends on beating the IRS rate. You also need enough income or other assets to live on during the trust term, since the annuity payments may not be large enough to cover all your expenses.

GRATs are often used by business owners before a company sale or IPO, because they lock in the current (lower) value of the business for tax purposes, and then the sale proceeds grow inside the trust tax-free. They are also common for people with significant investment portfolios who expect market growth. The trade-off is cost and complexity: you will pay an attorney to draft the trust, a trustee to manage it, and you will file annual tax returns.

What happens to the money during the trust term

During the years the GRAT is active, you receive fixed annuity payments on a schedule you set — usually quarterly or annually. These payments are calculated when the trust is created and do not change, even if the assets inside perform poorly or exceptionally well. The trustee (often a bank or trust company, or sometimes a family member with professional guidance) manages the investments inside the trust and makes sure your payments are made on time.

The assets inside the GRAT continue to be invested and grow. If they grow faster than expected, that extra growth stays in the trust and will eventually go to your beneficiaries. If they grow slower than the IRS rate, the trust may not have enough to pay you the full annuity amount, and you could receive less than planned — though the trustee is still legally required to pay what was promised, which may mean selling assets.

What happens when the trust term ends

When the GRAT term expires, whatever money or assets remain in the trust pass directly to your beneficiaries according to the trust document. This transfer happens outside of probate and without a new gift tax assessment. Your beneficiaries receive a "stepped-up" tax basis on the assets, meaning if they later sell them, capital gains taxes are calculated from the value on the date the trust ended, not from the original value when you funded it.

If you named multiple beneficiaries, the trustee divides the remaining assets according to your instructions. If you named a charity, the charity receives its share. The key advantage is that all this happens without additional gift or estate tax, as long as the trust was structured correctly and you survived the entire term.

The critical requirement: you must survive the trust term

For a GRAT to deliver its tax benefits, you must be alive when the trust term ends. If you die before the term is complete, the remaining assets in the trust are pulled back into your taxable estate, and the tax savings disappear. This is why shorter terms (two to ten years) are common — they reduce the risk that you will not survive the term, and they let you create multiple GRATs over time to spread the wealth transfer across several periods.

Some people create "rolling" GRATs, funding a new one every year or every few years. This way, if you die during one term, the others still deliver their benefits. It also lets you take advantage of lower Section 7520 rates in different years, because each GRAT is valued separately based on the rate in effect when it is created.

Costs and professional help you will need

Setting up a GRAT requires an attorney experienced in estate planning and trusts. The legal fees vary by location and complexity, but typically range from several hundred to several thousand dollars. You will also need to choose a trustee — either a professional trustee (a bank or trust company) or a family member, though a professional is often recommended because they have no conflicts of interest and know how to handle the investments and payments correctly.

Once the GRAT is created, you will file a federal income tax return (Form 1041) for the trust each year it exists. The trustee handles most of this work, but you will need to provide information about the trust's income and your annuity payments. These ongoing costs are usually modest compared to the potential tax savings, but they are real and should be factored into your decision.

Frequently Asked Questions

What is the difference between a GRAT and a regular annuity?

A regular annuity is a contract with an insurance company where you pay a lump sum and receive payments for life or a set period. A GRAT is a trust you create that holds assets, pays you annuity-like payments, and then passes the remainder to beneficiaries. The GRAT's main purpose is tax planning for wealth transfer, while a regular annuity is primarily an income tool.

Can I change my mind and take the assets out of the GRAT early?

Once a GRAT is funded and created, you cannot straightforward withdraw the assets without tax consequences. The trust is irrevocable, meaning you have given up control of the money. If you need access to the principal, you would have to terminate the trust, which triggers gift tax on the value of assets going to beneficiaries. This is why GRATs work best when you are confident you will not need the money during the term.

What if the assets in the GRAT lose money?

You still receive your full annuity payments, even if the trust's investments decline. The trustee must pay you the promised amount, which may mean selling assets at a loss. If the trust does not have enough to pay you and fund the remainder for beneficiaries, the beneficiaries receive less — but your payments are protected by law.

Do I pay income tax on the annuity payments I receive?

Yes. The annuity payments you receive are taxable income to you in the year you receive them. The tax treatment depends on what is inside the trust (interest, dividends, capital gains), and your tax professional can explain how much you owe each year. This is different from the gift tax benefit, which applies to the remainder passing to beneficiaries.

Can I use a GRAT if I do not have a large estate?

A GRAT is most cost-effective for people with significant assets, because the legal and trustee fees are substantial relative to smaller amounts. If your estate is under $500,000 or so, the tax savings may not justify the expense. However, if you have a specific asset you expect to grow sharply — like a business or concentrated stock position — a GRAT can still make sense at a smaller scale.