Want to avoid paying estate taxes twice? Get a generation-skipping trust.

If you have a large estate, one that will probably be subject to federal estate taxes, you might want to consider a generation-skipping trust. It is a great tool for capital preservation because it saves you, your estate, and heirs from being subject to a significant amount of taxes. Here is some basic information, as well as restrictions you should know about, concerning a generation-skipping trust.

What is a generation-skipping trust?

First, the trust is a legally binding, irrevocable trust. This means that the grantor relinquishes ownership of the assets in the trust once it is established. It cannot be modified by the trustor without the permission of its beneficiaries.

Second, the beneficiary of the trust should be a group that is two or more generations below the grantor. This means that the beneficiary should be at least be 37 ½ years younger than the trust grantor.

Interestingly, bloodline is not necessary for this type of trust - the beneficiary could be your friend, a great-nephew, or practically anyone else. The only requirement is that they need to be 37 ½ years younger than you.

By utilizing a generation-skipping trust, you are “skipping” one round of the inheritance tax, which can be a very significant benefit depending on the size of your estate. If you directly pass your money onto your kids, it will be subject to taxes. When your children pass away and decide to transfer this money to their kids, it will be subject to another round of taxes. By using a generation-skipping trust, the money is not taxed in the first generation at all - it goes directly to the second generation. And though the owners of the assets in the trust are not your children, they will benefit from this trust both by being able to indirectly gain access to the trust, and by being exempt from any taxes they would have paid if they were to directly inherit the money. 

Is a generation-skipping trust right for you?

Generation-skipping trusts are great for: making sure you provide for your grandchildren, and avoiding estate taxes (for large estates).

However, a generation-skipping trust has significantly fewer benefits to offer for smaller estates. It is certainly possible to create one if you want, but it is a quite complicated process and is probably not worth the effort.

You also need to keep in mind that there is a limit to the amount you may want to pass on through the trust. To understand this, you first need to know about the several taxes that are closely related to a generation-skipping trust. 

The first is the estate tax. Your estate will be subject to this tax if it is worth more than the estate tax exemption, which is $11.58 million (in 2020) or $11.7 million (in 2021) at the federal level. You need to be on the lookout for changes in the tax exemption amounts because they change annually due to inflation.

Estate taxes vary drastically depending on states as well; states can set their own tax rates. Furthermore, some state estate tax exemption levels are less than $1 million, while others are on the same level as the federal exemption. Find out where your state lands on this question by clicking here.

The second is the gift tax. This is a type of tax levied on “gifts” to others. These gifts can be any of your assets, such as money or property. No taxes will be imposed unless it surpasses the lifetime gift exemption limit of $11.58 million (in 2020) or $11.7 million (in 2021). There is also an annual exclusion of $15,000, and if you give a gift that exceeds this amount in a given year, that excess amount counts toward your lifetime gift tax exemption limit. This means that if you gave a gift of $1 million + $15,000 to your friend this year, the $1 million which was the excess amount will decrease your lifetime gift tax exemption limit to $10.58 million.

The last, and perhaps most important, tax is the GST tax - also known as the generation-skipping transfer tax. This tax was enacted by Congress to close the loophole that allowed people to avoid estate taxes. Congress also lumped estate, gift, and generation-skipping transfer taxes into one, and made it apply to any estate which exceeds the exemption threshold. The exemption threshold is, again, $11.58 million (in 2020) or $11.7 million (in 2021) at the federal level. If you are married, this exemption limit becomes approximately $23 million for you and your spouse combined. So generation-skipping trust distributions above the threshold are subject to the generation-skipping trust tax (which is a flat 40% tax) as defined by the federal tax code, along with any state inheritance, gift, or estate taxes that apply. Therefore, you should probably avoid surpassing this limit on a generation-Skipping trust because you will be taxed a significant amount, with all three taxes mentioned above piling on top of each other. 

Creating a generation-skipping trust can be a very complicated process. You may decide to create one yourself, but if you have any further questions, please check out our broader piece on trusts to see if any other trusts work well for you. If you require further assistance, feel free to make use of the concierge service here at Peacefully. We assist with referrals to trusted estate professionals, offering case-specific advice, recommendations, and coordination for you. For more about our concierge service, or to schedule a free 30-minute consultation, click here.

— Lucy Jung