A grantor retained annuity trust (GRAT) is a financial tool used in estate planning to reduce taxes on substantial monetary transfers to family members. An irrevocable trust is established for a specific term or amount of time under these plans. When a trust is founded, the person who establishes it pays a tax. The assets are deposited in the trust, and an annual annuity is paid out. When the trust ends, the assets are distributed to the recipient tax-free.
What is the difference between a trust fund and an annuity?
You make a donation of cash, securities, or other property to a trust with a charitable annuity. In turn, the trust will pay you or another beneficiary annual benefits. This ensures a steady annual income for you or your beneficiaries. When the trust expires, the remaining funds are distributed to the charity of your choice. A benevolent annuity can be created for up to 20 years, but it will automatically stop when the beneficiary passes away. This may enable you to make a donation that will benefit you during your lifetime but will be handed on when you pass away.
Why put an annuity in a trust?
In advocating trusts to many of my clients and prospects, I’ve encountered circumstances where someone wished to use a trust for a purpose other than traditional estate planning.
Some people have wondered if using an annuity to fund a trust or transferring an annuity into an existing trust is ever a good idea. The client in several of these cases sought to start funding beneficiaries while still living. An annuity appeared to be a viable option for achieving this goal.
While this scenario is not uncommon, and in some cases, placing an annuity in a trust can help clients achieve specific objectives, the correct annuity must be linked with the right trust. Annuities, as you may be aware, are given advantageous tax status in the United States. Section 72 of the Internal Revenue Code is dedicated primarily to annuity products and their tax treatment.
IRC Section 72’s favorable rules are intended to encourage the use of annuities as a retirement savings and/or income vehicle. As a result, it’s only natural that these regulations apply when a real, breathing human being holds an annuity directly.
This is why, when putting an annuity in a trust, you must exercise extreme caution or risk losing the annuity’s favorable tax treatment.
When an annuity is not held by a “natural person,” IRC Section 72 (u) limits this preferential treatment. Gains from an annuity owned by a non-natural person, such as an LLC, corporation, or other business, constitute taxable income. The only exception to this rule is if an annuity is held by a certain form of trust functioning as a “agent for a natural person” under certain conditions.
Unfortunately, there is little to no clarity when it comes to some terminology, as is the case with much of our tax system. It’s difficult to know exactly what the word “agent for a natural person” means when it comes to annuities held in a trust. Even the accompanying Treasury Regulations are silent on this concept. The many types of trusts that could potentially possess an annuity without jeopardizing its tax-deferred status have been established through a succession of Private Letter Rulings (PLRs) over the years.
PLR’s have found, for example, that certain types of trusts, like as a bypass trust for the benefit of a surviving husband and/or children, can keep their tax-favored status. If other beneficiaries (for example, a charity) are included in the trust, the annuity may lose its favorable treatment. The general rule is that in order for a trust to qualify as an agent for a natural person, the trust’s income and remainder beneficiaries must always be natural persons.
There are a few situations where putting your annuity in a trust makes sense. Placing an annuity in a trust, for example, ensures that you retain control over the annuity even if you are unable to administer it yourself.
Individual Retirement Accounts (IRAs) are another situation. While you can’t hold an annuity as an IRA for tax purposes, you can put one into a living trust with your spouse as the beneficiary. This ensures that if you die before your spouse, the annuity’s lump-sum payout in the trust can be carried over into your spouse’s IRA. By putting that annuity into a living trust, it will continue to pay your spouse until he or she goes away. The remaining funds might be distributed to the spouse’s beneficiaries.
If your financial advisor believes that putting an annuity into a trust will benefit you, find out how he or she came to that conclusion and make sure it aligns with your personal objectives. You should also seek the advice of a skilled tax attorney or CPA for a second view.
While trusts can own annuities and move them in and out, you must fully understand the details of that trust. Otherwise, you risk making costly mistakes that cost you thousands of dollars in unpaid taxes.
Always consult a licensed and authorized professional before making a permanent decision, as with all major decisions.
What are the disadvantages of a trust fund?
A living trust has its own set of issues and challenges. Most people believe the advantages outweigh the disadvantages, but you should be aware of them before creating a living trust.
Paperwork
A living trust isn’t difficult or expensive to set up, but it does necessitate some paperwork. Create and print a trust document, which you should sign in front of a notary public. It’s no more difficult than writing a will.
However, there is one more step that must be completed in order for a living trust to be effective: you must ensure that all of the property stated in the trust instrument is legally transferred to you as trustee of the trust.
However, if an item has a title document, such as real estate, stocks, mutual funds, bonds, money market accounts, or cars, the title document must be changed to reflect the property being held in trust. If you wish to put your house into your living trust, for example, you’ll need to create and sign a new deed transferring title to you as the trust’s trustee (or, in Colorado, to the trust itself). How to Transfer Titled Property to a Trust describes how to do it.
FOR EXAMPLE, Monica and David Fielding placed their home in a living trust to avoid probate, but later decided to sell it. Monica and David write their names “as trustees of the Monica and David Fielding Revocable Living Trust” in the real estate contract and deed transferring possession to the new owners.
Record Keeping
After you’ve set up a revocable living trust, you’ll just have to keep a few records on a daily basis. As long as you are both the grantor and the trustee, no separate income tax records or returns are required. (See IRS Regulation 1.671-4.) The revenue from the living trust’s property is reported on your personal income tax return.
When you transfer property to or from the trust, you must keep written records, which isn’t onerous until you transfer a lot of property in and out of the trust.
Transfer Taxes
Transfers of real estate to revocable living trusts are usually exempt from transfer taxes imposed on real estate transfers in most states. However, in some states, transferring real estate to a living trust may result in a tax. (For more information, see Transferring Titled Property to the Trust: Real Estate.)
Difficulty Refinancing Trust Property
Some banks and title agencies may refuse to refinance trust real estate since the legal title is held in the name of the trustee. They should be satisfied if you show them a copy of your trust document, which expressly grants you the authority to borrow against trust property as trustee.
If you can’t persuade a reluctant lender to work with you as trustee, you’ll either have to find another lender (which shouldn’t be difficult) or transfer the property out of the trust and back into your name. You can transfer it back into the living trust once you refinance.
No Cutoff of Creditors’ Claims
Most people are unconcerned that creditors may try to recover huge debts from their estate after they die. In most cases, the surviving relatives simply pay the legitimate debts, such as overdue bills, taxes, and medical and funeral expenses from the previous illness. However, if you’re worried about huge claims, you might opt to let your property go through probate rather than a living trust.
Creditors have a limited period of time to pursue claims against your estate if it goes through probate. A creditor who was properly advised of the probate court procedure is barred from filing a claim after the time limit, which in most states is six months, has passed.
EXAMPLE: Elaine is a real estate investor with a sizable property portfolio. She owes a lot of money and is frequently named in litigation. It might be in her best interests for her assets to go through probate, which bars creditors who are properly notified of the probate case from pursuing claims.
When property isn’t probated, creditors still have the right to be paid from the property (assuming the debt is valid). However, there is no official claim procedure. The creditor may not know who inherited the property of the deceased debtor, and once the property is discovered, the creditor may be forced to launch a lawsuit, which may not be worth the time and expense.
You must let all of your property move through probate if you wish to take advantage of the creditor cutoff. If not, the creditor may be able to sue you (even after the probate claim deadline) and try to collect from the property that didn’t go through probate and instead passed through your living trust.
Can an annuity be in a trust?
At the time of application, trusts can also serve as the owner of an annuity. A natural person must serve as the annuitant while purchasing a new annuity. Because annuities can pay out for the rest of the annuitant’s life, the policy could pay out indefinitely if a trust was named as the annuitant. The trust might be the owner of the insurance as well as the named beneficiary. You have the option of purchasing the annuity with your own money, which the trust then owns, or putting money into the trust, which the trust then uses to buy the annuity against your life.
How are GRATs taxed?
How Do GRATs Get Taxed? The income you earn from the appreciation of your assets in the trust is subject to regular income tax, and any remaining funds/assets that transfer to a beneficiary are subject to gift taxes.
Can the owner of an annuity also be the beneficiary?
While the annuity owner and annuitant may be the same person, the beneficiary is a distinct individual or business. The beneficiary is the individual who is entitled to the annuity’s residual cash value once the annuitant or annuitants die.
Spouse beneficiaries are allowed to take over as the annuity’s owner, continuing to receive regular payments while delaying income tax. Non-spouse beneficiaries are not affected in this way. The manner in which spouse and non-spouse beneficiaries are needed to collect the funds is one of the most significant differences between them.
Can a trust be the owner and beneficiary of an annuity?
Annuities have long benefited from favorable tax treatment, which is so wide that they have their own section of the tax code, IRC Section 72. The favorable rules are designed to encourage the use of annuities as a vehicle for retirement savings and/or retirement income… and as such, they only apply in instances where annuities are owned directly by individual, live, breathing human beings who may one day retire (known in the tax code as “natural persons”).
As a result, whether annuities owned by trusts continue to grow tax-deferred is dependent on the trust’s specific characteristics. When a trust owns an annuity “as an agent for a natural person,” such as when it’s owned by a revocable living trust, the contract can still keep its tax-deferral treatment; even if only all the beneficiaries of the trust are natural persons, such as with a bypass trust for the benefit of a surviving spouse and children, favorable treatment is still available. If other beneficiaries, including charities, are involved, a trust-owned annuity may lose its special treatment.
When annuity contracts are moved to or from a trust, the intersection between annuities and trusts becomes even more complicated. The issue is a major component of the tax code designed to prohibit unrealized annuity gains from being transferred to another person through giving; as a result, if an individual transfers an annuity “without full and adequate consideration,” the gains are recognized immediately. Although this rule does not apply to transfers to a revocable living trust or most types of transfers out of a trust, the situation remains unclear in the case of some common estate planning techniques, such as gifting an annuity to an Intentionally Defective Grantor Trust (IDGT), and clients and their advisors must be cautious not to create an unfavorable taxable event!
Are Annuities part of an estate?
All assets titled in your name become part of your estate when you die. There is a maximum estate valuation exemption for federal tax purposes and for states that impose estate taxes before taxes are applied. Your annuity death benefits are normally not included in your taxable estate if they go to your spouse. The death benefit is included in your estate valuation if it goes to any other beneficiaries.
Are annuities in a trust taxable?
IRC Section 72 provides for tax deferral for annuities owned by trusts that act only for the benefit of living individuals (u). The appreciation of an annuity that meets the requirements of IRC Section 72(u) is tax-deferred until the trustee requests a distribution.
Do Annuities have death benefits?
Annuities can help you fund your retirement. Most annuities, however, include a standard death benefit. This allows you to leave annuity assets to an heir after your death.
Who is the beneficiary of an annuity?
The annuity benefit payments are computed based on the annuitant’s life expectancy, and the owners are frequently annuitants. When an annuitant dies, a beneficiary receives the death benefits, which are usually the remaining contract value or the amount of premiums less any withdrawals.
