What Is an Intentionally Defective Grantor Trust?

An intentionally defective grantor trust (IDGT) offers you a tool for estate planning that allows you to isolate your assets for all but income tax purposes.

“Intentionally defective” might seem counterintuitive, but the name refers to the fact that the trust allows you to continue to pay income taxes on the assets in the trust. Still, the trust remains frozen to estate taxes. This is the deliberate “defect” involved.

How does it work?

Let’s say that you have several shares of stock, and their value has increased considerably over the period of your ownership. These shares also pay out dividends each year.

Were you to sell the shares to an IDGT, you might receive in return a 15-year promissory note valued at roughly the equivalent to the as-yet-untaxed gains on the stock, but which also bears interest of 3%.

You would pay income taxes, but there are circumstances in which you might realize estate tax savings if your shares’ dividends and appreciation were higher than the interest borne by the promissory note.

For this reason, IDGTs are probably best used during periods with lower inflation.

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While IDGTs have benefits under certain economic conditions, they can also potentially diminish your chances of incurring estate taxes upon your death. They also offer the added benefits afforded to most trusts to avoid direct taxation.

If you’re interested in learning more, talk to your trusted financial professional about how an IDGT might work with your estate strategy.