Generation-skipping tax: How it can affect your estate plan

Trust and Estate planning

Key takeaways

  • The generation-skipping tax is separate from the estate tax; the rules apply when you transfer assets to recipients two or more generations younger than you.
  • You may want to consider taking advantage of the lifetime exemption from the GST tax, which may be applied to any combination of transfers during your life or made at the time of death.
  • Transfer strategies include generation-skipping transfers and a direct generation skip, both of which may involve placing assets in a trust.

Estate taxes can be hefty. One strategy to reduce estate taxes in your family over time is to “skip” a generation of heirs. While this strategy can be successful, it’s not necessarily tax-free.

The generation-skipping tax (GST), also referred to as the generation-skipping transfer tax, prevents you from deliberately skipping your children in your estate plan in favor of younger generations to bypass potential estate taxes due upon your children’s deaths. However, there are exemptions and exclusions to the GST, which may create long-term wealth-building opportunities.

How the generation-skipping transfer tax rate is assessed

GST rules apply to asset transfers to recipients, usually grandchildren, who are two or more generations younger than you. Transfers to your own children are not considered generation-skipping. Assets transferred to a grandchild whose parent (your child) is deceased are not subject to the GST tax.

The GST tax is separate from, and in addition to, the estate tax. The tax is currently calculated at a flat rate of 40% (equal to the estate and gift tax rate) on transfers above the lifetime GST tax exemption amount (currently $12.06 million per individual).

The lifetime exemption from the GST offers some advantages. It may be applied to any combination of transfers during your life or made at the time of death.

The exemption amount, which is nearly double what it has been in years past, will grow each year based on inflation through 2025. Unless Congress intervenes, the exemption amount will revert in 2026 to a $5 million baseline, indexed for inflation.

The GST tax rate applies to outright transfers of property and certain other transfers of property to a trust. Generally, trust income or principal distributed to grandchildren are subject to GST.

Common transfer strategies for you to discuss with your tax and legal advisors

  • Generation-skipping transfers: You typically place your assets in a trust (which must be drafted by an attorney) using your GST exemption. The trust could pay income to your child for life with the remainder passing outside of your child’s taxable estate to your grandchildren or future generations after your child is deceased.
  • Direct generation skip: You bypass your own children and give the assets qualifying for the exemption amount either directly to your grandchildren or place assets in a trust for their benefit or for the benefit of future generations.

How to use a lifetime exemption from GST

The lifetime exemption from the GST offers some advantages. It may be applied to any combination of transfers during your life or made at the time of death.

Here are two potential strategies to consider when using the lifetime exemption:

  • During your lifetime, you make a gift of up to $12.06 million into a trust that ultimately distributes assets to your grandchildren, sheltering projected appreciation for future generations.
  • At your death, you may leave up to $12.06 million in lifetime trusts for your children. At your children’s deaths, the trusts’ $12.06 million (plus any appreciation) passes to your grandchildren without incurring a GST or estate tax.

The federal estate, gift and generation-skipping tax exemptions are unified and indexed for inflation in future years. There is one important difference, however. With an estate tax, the unused exemption of the first spouse to die can be added to the surviving spouse’s personal exemption. The same flexibility does not apply to the GST exemption. Any of the GST exemption unused at your death is lost.

Tax-exempt gifts

The GST does not apply to qualified nontaxable gifts. These include, but are not limited to:

  • Annual exclusion gifts of up to $16,000 per recipient per year (current amount, indexed for inflation in future years).
  • Payments for tuition, medical care or medical insurance made directly to a school, doctor, hospital, etc.

Gifts made for the benefit of a grandchild in these forms are generally tax-free.

Plan ahead to limit unnecessary taxes

You have the flexibility to make generation-skipping transfers during your lifetime or to plan for them to occur after your death.

During your lifetime, all applicable transfers of wealth that you make are automatically applied to your lifetime GST exemption, unless you elect otherwise. For transfers at death, the exemption may be allocated as you direct in your will or as your executor directs if unspecified in your will.

The rates and rules for generation-skipping taxes can be complicated and subject to change. Work with your tax, legal and financial professionals to determine if and how to implement GST exemptions as part of your estate plan.

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