The estate tax hits relatively few Americans, but those whom it does affect face a heavy burden. With a rate of 40%, the estate tax is onerous enough to warrant taking action to avoid at all costs. In particular, those who intend to leave assets to grandchildren or younger heirs through what are known as generation-skipping trusts, GST trusts, or dynasty trusts need to consider the added burden of generation-skipping transfer tax. Generation-skipping trusts can incur this tax, but if they are established properly under the correct rules, they can also help you by letting you sidestep tax liability.
What a generation-skipping trust is
Generation-skipping trusts involve skipping a generation in planning your estate. Most people leave their assets to a surviving spouse, and then to their children. What distinguishes a generation-skipping trust is that it provides for assets to go directly to grandchildren, great-grandchildren, or other young descendants, who are known collectively as "skip persons."
The simplest generation-skipping trust involves only grandchildren as the eligible beneficiaries. However, the more common generation-skipping trust involves multiple generations of beneficiaries, and it can take years or even decades before grandchildren and other skip persons become eligible to receive distributions from the trust.
How to set up a generation-skipping trust to avoid tax
In general, generation-skipping trusts are subject to a second level of tax liability beyond gift and estate taxes, with the 40% tax rate applying on top of any regular estate tax liability. That treatment ensures that assets go through two rounds of taxation in order to go down by two or more generations, which is consistent with what would happen if the assets were first given to children and then passed to grandchildren at the child's subsequent death.
However, you can structure generation-skipping trusts to take advantage of the lifetime exemption that applies to the generation-skipping transfer tax. You can fund a generation-skipping trust with up to $5.45 million in 2016 and allocate your lifetime exemption to the trust in order to avoid future GST tax liability. Once the trust is funded and the exemption applied, future appreciation in the trust assets is allocated to the trust beneficiaries directly. If the trust is irrevocable, you won't have to pay GST tax even if the value of the trust assets rises after your gift is complete.
Other things to keep in mind
In addition to the lifetime exemption, you also have the right to make annual exclusion gifts to skip persons without incurring the GST tax. For 2016, the maximum annual gift is $14,000, and you can make gifts to as many different grandchildren, great-grandchildren, or others as you like.
Also, some intricacies in the legal definition of a skip person can be confusing. For example, most of the time, grandchildren will be skip persons, and therefore subject to tax if they are named as direct beneficiaries of a generation-skipping trust. However, there's a special "deceased parent" rule that says that if a grandchild's parents have passed away, then gifts from grandparents to that grandchild aren't considered to be skip gifts subject to generation-skipping tax.
Because of the complexities involved with generation-skipping trusts and the taxes that accompany them, it's best to get professional help to set up a trust with provisions that will take maximum advantage of the generation-skipping transfer tax lifetime exemption. The high cost of the tax makes this element of generation-skipping trust planning among the most complicated for high-net-worth estate plans. However, the effort you go to now can pay off with massive tax savings for future generations, and that makes it worth getting legal assistance to plan accordingly.
The $15,834 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $15,834 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after.Simply click here to discover how to learn more about these strategies.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.