An Estate Planning Strategy That Can Help Lower Estate and Gift Taxes
If you’re hoping to pass on significant wealth free from estate taxes to your loved ones while also spending down most of your assets during your lifetime, an intentionally defective grantor trust (IDGT) may be an option to consider.
What is an IDGT?
An IDGT is a trust that allows the grantor to separate certain assets for federal income tax purposes. Because the grantor intentionally claims ownership of the trust, he/she is responsible for paying taxes on the trust’s income. However, any appreciation within the trust is excluded from the grantor’s assets for estate planning purposes. This exclusion can help maximize the amount received by trust beneficiaries.
How an IDGT works
As the grantor, you would place assets into an irrevocable trust, either as a gift or asset sale. If the transaction is considered a “sale,” you would receive a promissory note with an associated interest rate. The trust would then pay you an established interest rate over the term of the loan, and you must pay taxes on any interest received. The goal is for the trust’s assets to grow at a rate that exceeds the amount paid in interest. It’s worth noting, however, that the assets within an IDGT aren’t eligible for a step-up in cost basis upon the grantor’s death.
Why is it called “defective”?
Typically, assets placed in an irrevocable trust are intended for designated beneficiaries, and the trust’s grantor retains no control over the trust. An IDGT is considered “defective” because the grantor retains ownership and control of the trust’s assets for income tax purposes. Of course, this defect is “intentional” because the grantor wishes to pay taxes on the trust assets in order to minimize the tax burden on his or her heirs.
Income tax benefits
IDGTs allow assets within the trust to grow without tax implications because the trust’s grantor pays taxes with outside assets. This move can help remove a significant tax drag from the trust itself, thereby increasing the amount available to beneficiaries.
For example, say you establish a $10 million IDGT for your heirs. Assuming a 5% annual rate of return, the trust would be worth approximately $43 million in 30 years. The same $10 million invested in a typical irrevocable trust with a 5% rate of return would be worth only $24 million in 30 years, because taxes would have been paid from trust assets throughout the life of the trust.
This image shows the difference in trust value after 30 years of putting $10M into either an intentionally defective grantor trust ($43M) or a non-grantor trust ($24M). Source: https://www.bnymellonwealth.com/insights/maximize-next-generation-assets-with-intentionally-defective-grantor-trusts.html
Estate tax benefits
IDGTs have the added benefit of excluding assets from the grantor’s estate. Because assets are no longer in the grantor’s name, they aren’t counted toward the grantor’s lifetime estate tax exemption.
Using the example above of a $10 million IDGT investment that grows to $43 million in 30 years, only the $10 million originally contributed to the IDGT would count toward the federal gift and estate tax exemption. That means $33 million in additional assets can transfer to the trust’s beneficiaries without being subject to income tax.
Asset protection benefits
IDGTs also offer the benefit of asset protection, as they shelter assets from creditors in the case of financial struggles, debt or divorce. This protection applies as long as assets were not transferred to the trust in an effort to defraud a creditor.
Is an IDGT right for you?
IDGTs are complex planning strategies that don’t make sense in every situation. Before establishing an IDGT, be sure to work with a qualified wealth manager and estate planning attorney to determine whether this strategy is right for you.
At Creative Planning, we help our clients implement a wide range of estate planning strategies, including IDGTs. As a nationally recognized wealth advisory firm, we deliver a team of credentialed, educated, experienced and action-oriented advisors, including CERTIFIED FINANCIAL PLANNER™ practitioners, Certified Public Accountants, insurance specialists, attorneys and other professionals dedicated to helping you achieve your goals. We work together to help ensure all aspects of your financial life are well cared for.
For more information about whether a IDGT makes sense for your personal financial situation, please schedule a call.
