If you ever did something particularly dumb around my grandmother, there was a good chance she would call you an “idgit.”
Thankfully, estate planners aren’t insulting anyone when they talk about an IDGT. In fact, an Intentionally Defective Grantor Trust is a sophisticated estate-planning strategy where being “defective” is exactly what you want.
The name sounds like someone made a mistake, but that is not the case.
An Intentionally Defective Grantor Trust is designed so that the grantor is still treated as the owner of the trust for income tax purposes, even though the assets can be outside the grantor’s estate for estate tax purposes.
In other words, the trust is “defective” on purpose.
So why would you do this?
Because the combination can be extremely useful when you’re trying to move future appreciation out of an estate.
Imagine you have an investment worth $2 million today. You expect it to appreciate significantly over the next 10 to 20 years. If you keep the investment in your estate, all of that future growth potentially remains part of your taxable estate.
An IDGT can be used to move the asset out of the estate today, allowing its future appreciation to occur outside of the estate.
That is the heart of the strategy.
Here’s where the IDGT gets a little weird.
Even though the assets may no longer be included in the grantor’s estate, the grantor can still be responsible for the income taxes generated by those assets.
This may sound backwards, but that’s one of the benefits. Because the trust is treated as a grantor trust for income-tax purposes, the income is reported on the grantor’s individual tax return rather than being subject to the trust’s compressed tax brackets. At the same time, the grantor’s payment of those taxes allows the trust’s assets to remain invested and continue growing for the beneficiaries.
It’s a tad counterintuitive, but that’s what makes an IDGT so interesting.
So, while my grandmother may have called someone an “idgit” for doing something, an IDGT is intentionally “defective” for a good reason.