The first advice any investor gets is to diversify – to buy several stocks, for example, so gains on some have the potential to offset losses on others. But one very effective estate planning tactic, called a GRAT, relies on segregating, not combining, your assets.

A Grantor Retained Annuity Trust, or GRAT, is a very useful technique to reduce estate and gift taxes when transferring assets from one generation to another.

To set up a GRAT, a parent or other donor establishes an irrevocable trust for a specified period of time, names a beneficiary, and places assets in that trust. An annuity is paid out to the donor periodically during the life of the trust. The annuity payments include a portion of the principal plus a “reasonable” return (as defined by the IRS) on the investment. At the end of the period,  anything left in the trust goes outright or in trust to the beneficiary, free of gift tax.

Let’s look at a hypothetical example.

Dad and Mom want to transfer some of their wealth to their daughter, Susan. The set up a GRAT with a two-year term, deposit in it a portfolio of stocks worth $1 million, and name Susan as the trust’s beneficiary.

During the first year, the stocks appreciate in value by 7%, to a value of $1,070,000. Because it is a two-year annuity, the parents must withdraw about half of the principal, plus interest at the so-called “Section 7520” rate specified by the IRS. Currently that’s 1.8% per year. So their withdrawal would total about $513,500.

That would leave about $556,500 in the trust for Year Two. Let’s assume it continues to grow at 7%, reaching a value of $595,000 at the end of the second year. Again the parents must withdraw about $513,500. The remainder of $81,500, goes to Susan, tax-free.

As this example demonstrates, a GRAT can be a very useful part of an estate-planning strategy.

But there’s a way to make it even more effective. Instead of putting a portfolio of stocks into a single GRAT, we can put each stock into its own GRAT.

As we noted at the beginning of this post, losses can offset gains in a portfolio of stocks. That may be a fine investment strategy, but it’s not what we want for a GRAT.

Let’s say Susan’s parents hold shares in four companies of equal value, and want to use these for their GRAT. Let’s also assume that two of these stocks steadily increase in value by 7% per year, while the other two steadily decline by that amount.

Because the gains are offset by the losses, the GRAT holding that portfolio of four stocks would be worth no more at the expiration of its two-year term than it was at the start. Susan would receive nothing.

The situation is very different, however, if those stocks are placed into four GRATs, with each GRAT holding only the shares of one company.

The two GRATs holding the shares that declined in value would be worth less at the end of the two years, so they of course would distribute nothing to Susan.

But each of the GRATs that held the shares that rose in value would be worth more, and Susan would receive that return (minus the 1.8% interest the IRS says must go to the parents) free of taxation.

Segregating the securities into separate GRATs preserves the gains, and achieves the parents’ goal of passing some of their wealth to their beneficiary tax-free.

There is no limit on the number of GRATs a donor can set up. If the donor has stock in 10 companies, he or she can establish 10 GRATs. Moreover, the money received by the donor at the end of Year One of a two-year GRAT can be put into a new GRAT. The same is true, of course, for the money received by the donor when the GRAT expires. These are referred to as rolling GRATs.

In our example we described a two-year GRAT. The term can be longer – in fact, the administration has tried to increase the minimum term to 10 years, so far without success. But a two-year term allows the gains to go to the beneficiary more quickly.

What happens if the stock held in a GRAT rises significantly long before the GRAT is set to expire? The donor can sell the shares; the proceeds remain in the trust, and can be reinvested in a savings account, bonds or other investments until the GRAT term ends.

In our examples, the GRATs held publicly-traded securities, but a GRAT can also hold real estate or shares of a family business. However, these assets would involve other important considerations, such as the need to liquidate them to make GRAT payments, or they can be distributed in kind, in which case an appraisal must be obtained.

Philip S. Magaram