Trusts are an essential topic in financial and estate planning. Numerous varieties exist, which can cloud the discussion. It’s helpful to understand the similarities and differences between types, starting with grantor and non-grantor trusts.
What is a grantor trust?
Grantor trusts contain assets that remain under the grantor's control (the person creating the trust). Grantor trusts can provide income to the grantor rather than to beneficiaries and are typically revocable. Grantor trusts are often established as an estate management tool, facilitating the distribution of assets after the grantor’s death.
Grantors retain control of the trust, including the selection of investments and the ability to exchange assets into and out of the trust or to borrow from it. Grantors can change beneficiaries and terminate the trust at any time (grantor trusts are typically revocable).
One crucial characteristic of grantor trusts is that since the creator controls the trust, they are responsible for any taxes due on income within the trust. While a revocable grantor trust will frequently ease the distribution of assets after the creator dies, these trusts do not provide tax benefits.
While most grantor trusts are revocable, there are some exceptions. None are common, but one example is an irrevocable income-only trust. The assets belong to the trust, but the grantor can receive the income. The grantor can’t remove assets from the trust.
How do non-grantor trusts work?
A non-grantor trust is controlled by a trustee, not by the grantor who created the trust. The grantor can’t make changes to the terms or beneficiaries or revoke the trust. In this case, since the grantor does not control the trust or receive the income, they do not pay taxes on its income. The trust files a separate tax return. The result of this distinction may be that the taxes imposed are lower if the trust has a lower tax rate than the creator.
A trustee selected by the grantor is the overseer of an irrevocable trust. Since the trust is irrevocable, it is a separate entity, and the grantor can’t usually change the trustee designation.
Is a GRAT a grantor trust?
GRATs (Grantor Retained Annuity Trusts) are a subtype of grantor trusts that individuals can use when they want to distribute an asset’s appreciation to an heir and reduce the amount of value that is subject to estate taxes. The grantor creates an irrevocable trust with a fixed term, usually no more than ten years.
During this period, the grantor receives an annual distribution from the trust as an annuity. The amount is based on a set percentage of the asset's value when the grantor created the trust, plus a specified interest rate. If the grantor is still alive when the trust terminates, the beneficiary receives the remaining value after the last annuity payment. If the grantor dies before the end of the term, the trust assets are returned to the estate.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
