You may be one of the lucky ones who is not only financially well-off yourself, but whose children are also financially set for life. The down side of this is that they also face the prospect of high taxes on their estates. You may also want to ensure that future generations of your heirs benefit from your prosperity. To reduce taxes and maximize your gifting abilities, consider skipping a generation with some of your bequests and gifts.
But your use of this strategy is limited. The law assesses a generation-skipping transfer (GST) tax equal to the top estate tax rate on transfers to a "skip person," over and above the gift or estate tax, though this tax is being repealed along with the estate tax. A skip person is anyone more than one generation below you, such as a grandchild or an unrelated person more than 37 1/2 years younger than you.
Fortunately, there is a GST tax exemption. Through 2003, this exemption is indexed annually for inflation, for a 2001 amount of $1.06 million and a 2002 amount of $1.1 million. But beginning in 2004, it will be equal to the estate tax exemption. (Also see Chart 2.) Each spouse has this exemption, so a married couple can use double the exemption. If you exceed the limit, an extra tax equal to the top estate tax rate is applied to the transfer—over and above the normal gift or estate tax.
Outright gifts to skip persons that qualify for the annual exclusion are also exempt from GST tax. A gift or bequest to a grandchild whose parent has died before the transfer is not treated as a GST.
Taking advantage of the GST tax exemption can keep more of your assets in the family. By skipping your children, the family may save substantial estate taxes on assets up to double the exemption amount (if you are married), plus the future income and appreciation on the assets transferred. (See Case Study.) Even greater savings can accumulate if you use the exemption during your life in the form of gifts.
If maximizing tax savings is your goal, consider a "dynasty trust." The trust is an extension of this GST concept. But whereas the previous strategy would result in the assets being included in the grandchildren's taxable estates, the dynasty trust allows assets to skip several generations of taxation. Simply put, you create the trust either during your lifetime by making gifts or at death in the form of bequests. The trust remains in existence from generation to generation. Because the heirs have restrictions on their access to the trust funds, the trust is sheltered from estate taxes. But if any of the heirs have a real need for funds, the trust can make distributions to them.
SKIPPING OUT ON ESTATE TAXES
Saul and Eleanor have accumulated a sizable estate, as have each of their children. Because their children are financially secure, Saul and Eleanor have structured their wills so that the full generation-skipping transfer (GST) tax exemption amount from each of their estates goes to their grandchildren after both of their deaths. By doing this, they are each able to take advantage of their generation-skipping transfer tax exemption. Although their estates must pay estate taxes, they avoid having their assets taxed again in their children's estates. They can also pass the future appreciation on those assets to their grandchildren tax free.
Material discussed is meant for general illustration and/or informational purposes only and it is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary therefore, the information should be relied upon when coordinated with individual professional advice.