Estate planning can help you pass on assets to your heirs while potentially minimizing taxes. When gifting assets, itâs important to consider when and how the generation-skipping tax transfer (GSTT) may apply. Also called the generation-skipping tax, this federal tax can apply when a grandparent leaves assets to a grandchild while skipping over their parents in the line of inheritance. It can also be triggered when leaving assets to someone whoâs at least 37.5 years younger than you. If youâre considering âskippingâ any of your heirs when passing on assets, itâs important to understand what that means from a tax perspective and how to fill out the requisite form. A financial advisor can also give you valuable guidance on how best to pass along your estate to your beneficiaries.
Generation-Skipping Tax, Definition
The Internal Revenue Code imposes both gift and estate taxes on transfers of assets above certain limits. For 2020, you can exclude gifts of up to $15,000 per person from the gift tax, with the limit doubling for married couples who file a joint return. Estate tax applies to estates larger than $11,580,000 for 2020, increasing to $11,700,000 in 2021. Again, these exemption limits double for married couples filing a joint return.
The gift tax rate can be as high as 40%, while the estate tax also maxes out at 40%. The IRS uses the generation-skipping transfer tax to collect its share of any wealth that moves across families when assets arenât passed directly from parent to child. Assets subject to the generation-skipping tax are taxed at a flat 40% rate.
This tax can apply to both direct transfers of assets to your chosen beneficiaries as well as assets passed through a trust. A trust can be subject to the GSTT if all the beneficiaries of the trust are considered to be skip persons who have a direct interest in the trust.
How Generation-Skipping Transfer Tax Works
Generation-skipping tax rules cover the transfer of assets to people who at least one generation apart. A common scenario where the GSTT can apply is the transfer of assets from a grandparent to a grandchild when one or both of the grandchildâs parents are still alive. If youâre transferring assets to a grandchild because your child has predeceased you, then the transfer tax wouldnât apply.
The generation-skipping tax is a separate tax from the estate tax and it applies alongside it. Similar to estate tax, this tax kicks in when an estateâs value exceeds the annual exemption limits. The 40% GSTT would be applied to any transfers of assets above the exempt amount, in addition to the regular 40% estate tax.
This is how the IRS covers its bases in collecting taxes on wealth as it moves from one person to another. If you were to pass your estate from your child, who then passes it to their child then no GSTT would apply. The IRS could simply collect estate taxes from each successive generation. But if you skip your child and leave assets to your grandchild instead, that removes a link from the taxation chain. The GSTT essentially allows the IRS to replace that link.
You do have the ability to take advantage of lifetime estate and gift tax exemption limits, which can help to offset how much is owed for the generation-skipping tax. But any unused portion of the exemption counted toward the generation-skipping tax is lost when you die.
How to Avoid Generation-Skipping Transfer Tax
If youâd like to minimize estate and gift taxes as much as possible, talking to a financial advisor can be a good place to start. An advisor whoâs well-versed in gift and estate taxes can help you create a plan for transferring assets. For example, that plan might include gifting assets to your grandchildren or another generation-skipping person annually, rather than at the end of your life. Remember, you can gift up to $15,000 per person each year without incurring gift tax, or up to $30,000 per person if youâre married and file a joint return. Youâd just need to keep the lifetime exemption limits in mind when scheduling gifts.
You could also make payments on behalf of a beneficiary to avoid tax. Say you want to help your granddaughter with college costs, for example. Any direct payments you make to the school to cover tuition would generally be tax-free. The same is true for direct payments made to healthcare providers if youâre paying medical expenses on behalf of someone else.
Setting up a trust may be another option worth exploring to minimize generation-skipping taxes. A generation-skipping trust allows you to transfer assets to the trust and pay estate taxes at the time of the transfer. The assets you put into the trust have to remain there during the skipped generationâs lifetime. Once they pass away, the assets in the trust could be passed on tax-free to the next generation.
This strategy requires some planning and some patience on the part of the generation that stands to inherit. But the upside is that members of the skipped generation and the generation that follows can benefit from any income the assets in the trust generates in the meantime. Trusts can also yield another benefit, in that they can offer asset protection against creditors who may file legal claims against you or your estate.
Another type of trust you might consider is a dynasty trust. This type of trust can allow you to pass assets on to future generations without triggering estate, gift or generation-skipping taxes. The caveat is that these are designed to be long-term trusts.
You can name your children, grandchildren, great-grandchildren and subsequent generations as beneficiaries and the transfer of assets to the trust is irrevocable. That means once you place the assets in the trust, you wonât be able to take them back out again so itâs important to understand the implications before creating this type of trust.
The Bottom Line
The generation-skipping tax could take a significant bite out of the assets youâre able to leave behind to grandchildren or another eligible person. If youâre considering using this type of trust to pass on assets or youâre interested in exploring other ways to transfer assets while minimizing taxes, itâs wise to consult an estate planning lawyer or tax attorney first.
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