Generation-skipping taxes may impact your estate plans

Estate tax rules have changed repeatedly over the years. When you plan your estate transfer, you will want to consider the impact of these taxes.

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

The generation-skipping transfer (GST) tax prevents you from avoiding all estate tax by making gifts directly to grandchildren or great-grandchildren. However, there are exemptions and exclusions to the GST, which may create long-term wealth-building opportunities. Here’s how the GST works.

How the generation-skipping tax rate is assessed

GST tax rules apply to asset transfers to recipients 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 calculated at a flat rate of 40 percent in 2018 (equal to the estate and gift tax rate) on transfers above the lifetime GST tax exemption amount (approximately $11.2 million).

The exemption amount will grow each year based on inflation through 2025. However, this exemption amount is nearly double what it has been in years past, and it is scheduled to sunset. Starting on Jan. 1, 2026, the exemption amount will return to the much lower level of the previous tax law. In 2026, the new rate will revert to a $5 million baseline, indexed for inflation.

The generation-skipping 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 tax.

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 tax exemption. This pays income to your child for life with the remainder passing 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 tax

The lifetime exemption from the GST tax offers some advantages. It may be applied to any combination of transfers during your life or made at the time of death. The lifetime GST tax exemption in 2018 is about $11.2 million.

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

During your lifetime, you make a gift of $11.2 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 $11.2 million in lifetime trusts for your children. At your children’s deaths, the trusts’ $11.2 million (plus any appreciation) passes to your grandchildren without incurring a GST tax or estate tax.

The federal estate, gift and GST 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 tax exemption. Any of the GST tax exemption unused at your death is lost.

Tax-exempt gifts

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

Annual exclusion gifts of up to $15,000 per recipient per year (2018 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 tax 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 tax rules as part of your estate plan.

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