When planning your estate, it’s important to use strategies that not only protect your wealth but also minimize taxes. One powerful tool for achieving this is an irrevocable trust, which can help reduce the size of your taxable estate, safeguard assets from creditors, and control how and when your wealth is passed down. A specific type of irrevocable trust, the intentionally defective grantor trust (IDGT), is particularly attractive for many individuals looking to optimize their estate planning.

What Makes IDGTs Unique?

IDGTs offer a unique combination of tax benefits and flexibility. They allow the grantor to make completed gifts while also reducing the taxable estate. The key feature of an IDGT is that the grantor, not the trust itself, is responsible for paying the income taxes on the trust’s income. This arrangement helps continue to reduce the grantor’s taxable estate without triggering additional estate and gift taxes.

The “Defect” That Provides Flexibility

To fully understand the advantages of IDGTs, it’s essential to grasp the concept of their “defect.” In most trusts, the trust itself must pay income taxes on any appreciation of the assets. However, with an IDGT, the trust document explicitly requires the grantor to pay those taxes. This allows the trust to grow without depleting its assets to cover tax liabilities, thereby benefiting the grantor by further reducing their taxable estate while retaining control over the assets.

The Power of Swapping Assets

Another compelling feature of IDGTs is the ability to swap assets within the trust. This strategy helps minimize future capital gains tax liabilities. Typically, the grantor funds the trust with assets expected to appreciate significantly. Over time, those assets are swapped with other, lower-cost-basis assets, such as cash. If the grantor keeps the highly appreciated assets until death, they receive a step-up in tax basis to the fair market value at the time of death, effectively reducing the capital gains taxes owed when those assets are eventually sold.

Why Paying Taxes Can Be Worth It

Although paying the income taxes for an IDGT might seem like an extra burden, it can be a strategic investment. By allowing the trust’s assets to grow without being taxed, the value of those assets can compound more rapidly. For instance, a trust that starts with $10 million, grows at 7% per year, and pays the top federal income tax rate of 37%, could appreciate to almost $38 million over 30 years. Without the tax burden, the assets could grow to $76 million. The ability to grow tax-free means that more wealth can be transferred to the beneficiaries.

Act Before the Estate Tax Exemption Reduces

Currently, the federal estate and gift tax exemption is at a historically high $13.61 million per individual (or $27.22 million for married couples), but this exemption is set to expire on December 31, 2025. If Congress does not act to extend these limits, they will revert to $5 million per person (adjusted for inflation) starting in 2026. Given this impending change, now may be the best time to fund an IDGT or other trust structures to take advantage of the current high exemption. While transfers exceeding the exemption amount may be subject to estate taxes, the potential appreciation of the assets could easily outweigh that tax liability.

Seek Guidance from Your Wealth Advisor

An IDGT is just one of many tools available for estate planning. Working with your wealth advisor, along with our in-house trust professionals, can help you determine if this strategy is the right fit for your financial goals. Together, you can create a plan that maximizes your wealth transfer while minimizing taxes.