Protect Against the Generation-Skipping Tax
When you die, if some or all of your estate bypasses your children and goes directly to a grandchild, your estate could have to pay a tax called the generation-skipping transfer (GST) tax.
What Is the GST Tax?
The generation-skipping transfer tax is a very expensive tax. It is equal to the highest federal estate tax rate in effect at the time, and it is in addition to the federal estate tax.
Skipping a Generation
Incurring this tax can happen in three ways:
- It can happen intentionally. For example, if you skip the living parent (your child) and leave an inheritance directly to your grandchild.
- It can happen unintentionally, as when an inheritance is in a trust for your child, and your child dies after you, but before receiving the full amount in the trust. Your grandchild will receive their deceased parents' remaining inheritance under the terms of the trust. At this point, it could then be subject to the GST tax.
- This tax also applies if you leave assets to a someone not related to you who is more than 37½ years younger than you.
The Origin of the Generation-Skipping Trust and GST Taxes
Why does generation-skipping tax exist in the first place? In the past, generation-skipping trusts were common, especially among the wealthy.
For example, a grandfather could set up a trust that distributed only income (no principal) to his children. The trust principal would be distributed later to his grandchildren and future generations.
This allowed the trust assets to grow estate tax-free and appreciate in value. It also avoided the heavy taxation that would have occurred if each generation had been taxed on the full inheritance. The Rockefellers are one family who used this concept to great advantage, building (and retaining) considerable wealth for several generations.
Eventually, of course, Uncle Sam decided he wanted his share of taxes, just as if each generation had received its inheritance and paid taxes on it. Today, if you bypass your children and leave substantial assets to your grandchildren, these assets may be subject to the GST tax.
The good news is that everyone has an exemption from this tax. In 2023, the GST tax exemption is $12.92 million for an individual. So you and your spouse could potentially leave up to $25.84 million to your grandchildren and future generations without having to pay the generation-skipping transfer tax.
(Note that the current gift and estate tax exclusion amounts are due to sunset at the end of 2025. Without Congressional action, these exclusions are slated to be cut by about half, to 2017 levels, adjusted for inflation.)
Just like the federal estate tax exemption, however, you have to plan ahead to avoid wasting one of these GST tax exemptions.
One way to plan ahead is with an ABC living trust. For a married couple with an ABC Trust in place, this type of trust might work as follows:
- When one spouse dies, the estate can be divided in half. Generally, half of the trust's assets would go to the surviving spouse through a revocable trust, Trust A.
- The other half of the couple's assets is then divided between Trusts B and C:
- The deceased spouse's GST tax exemption is applied to Trust B.
- Anything above the exemption (that would otherwise be subject to estate tax if it went to the surviving spouse) funds Trust C.
- When the surviving spouse dies, that spouse's GST tax exemption can be applied to Trust A.
This arrangement therefore makes full use of both spouses' exemptions.
This same planning can also be done in a will. However, you would not enjoy the many benefits of a revocable living trust.