Wealthy individuals are all very different, but when it comes to estate planning, they tend to share a few common goals: Minimizing transfer taxes, maximizing the value of assets passed to beneficiaries and preserving intergenerational wealth.
One highly effective tool for helping to achieve these goals is known for its somewhat odd name: the intentionally defective grantor trust (IDGT). IDGTs are a type of irrevocable trust that offer the powerful combination of tax efficiency, asset protection and retention of control.
The Defect That Works in Your Favor
IDGTs are considered “defective” because of intentionally created language that places responsibility for paying income taxes on the creator of the trust (the grantor) rather than the trust itself. Tax-free growth allows trust assets to potentially compound at a much faster rate, thus maximizing the wealth earmarked for beneficiaries. For example, a hypothetical IDGT that’s funded initially with $10 million and that earns 7% annually would grow to $76 million over 30 years. In a trust that paid its own income taxes—let’s say at the top federal rate of 37%—the final figure would be under $38 million.*
Tax Considerations
Bear in mind that transfers into IDGTs above the current estate and gift tax exemption ($12.9 million in 20231) are subject to federal income tax. But the more the trust assets appreciate over the years, the less significant any initial tax bill would appear by comparison. And while the fair market value of the gift is applied to the grantor’s estate tax exemption, the gift tax value is frozen at the time of the transfer.
Shrinking Your Estate
Shifting appreciating assets like real estate and securities into the trust is an effective way to manage the size of the grantor’s taxable estate. And the income tax that the grantor must pay on appreciation of trust assets can further reduce the grantor’s taxable estate.
You’re (Somewhat) in Control
One of the key characteristics of an IDGT is that, even though the trust is irrevocable, meaning the grantor can’t shut it down and take their assets back, the grantor does retain certain powers over the assets. They include the right to retrieve assets previously placed in the trust and substitute other assets for them, to take loans from the trust and to change trust beneficiaries.
The Benefit of Asset Protection
Another benefit of an IDGT is asset protection. Assets owned by IDGTs and other irrevocable trusts are shielded from potential creditors, lawsuits and other claims. This can be particularly valuable for individuals who have concerns about protecting their wealth for future generations or mitigating risks associated with their business or professional endeavors.
Tools such as IDGTs can be part of a well-crafted estate plan that benefits both grantor and beneficiaries alike. And funding one now, before the federal lifetime estate tax exemption expires, could be a wise move. Your wealth advisor and team can help you decide whether an IDGT strategy can help you achieve your goals.
1 “Estate Tax”
*The hypothetical example is for illustration purposes only and is not intended to be representative of actual results or any specific investment, which will fluctuate in value. The determinations made by this example are not guarantees or projections, and no fees or expenses are included in the calculations, which would reduce the figures shown. Please keep in mind that it is possible to lose money by investing, and the actual results will vary.
This article is being provided for informational and educational purposes only. It should not be construed as an individualized recommendation or personalized advice. Please contact your financial, tax, and legal professionals for more information specific to your personal situation. The information and opinions provided have been obtained from sources deemed reliable, but we make no representation regarding the accuracy or completeness of the information.
The use of trusts involves complex laws, tax rules, and regulations. Interested parties are strongly encouraged to seek advice from qualified tax, legal, and financial professionals before making any financial-related decisions.
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