Generation-skipping trust for estate planning 

As an estate planning tool, the generation-skipping trust can offer investors some tax advantages and other perks. For the family that uses it, this can be a way to have the third generation inherit a sizable estate without losing a large portion to federal estate taxes.  

This trust is an option if individuals do not wish to transfer assets to their children, choosing to leave more to their grandchildren and great-grandchildren instead. Investors can also leverage the trust to avoid paying taxes twice; this happens when the estate is passed to their children, and then taxed again when they pass it on to their grandchildren.  

An estate planning tool like this certainly raises important questions. Who gets the income from a generation-skipping trust? What is a generation-skipping transfer? Are there generation-skipping trust rules? Treat this article as a client education piece for your clients as InvestmentNews delves more into this estate planning tool.  

What is a generation-skipping trust? 

 A generation-skipping trust is a form of trust agreement that is legally binding. In a generation-skipping trust (GST), the assets are passed down from the creator of the trust, known as the grantor, to their grandchildren.  

From the name itself, the trust “skips” a generation and gives the assets and properties to the grantor’s grandchildren instead of their children. It seems odd for a grantor to do this, but this is done primarily to avoid paying estate taxes. The generation-skipping trust is designed mostly to benefit those with significant estates composed of large savings and other valuable assets.    

Estate taxes are taxes levied on any individual’s property upon their death, which only apply if the children directly inherited from the grantor. By placing estate assets in a GST, the trust works as a wealth preservation tool, effectively avoiding having to pay higher taxes and ensuring the next generation gets a significant inheritance.  

What kind of trust is a generation-skipping trust? 

A generation-skipping trust (GST) is a unique form of trust. It combines the elements of at least two other types of trusts: an irrevocable trust and a grantor trust.  

The GST is a grantor trust because it’s created by the grantor while they are still living. The GST is also an irrevocable trust, since its provisions cannot be changed or revoked.  

Another interesting fact about the GST: it is not just any legal agreement but a fiduciary one. The grantor has a fiduciary duty to act in the interests of their beneficiaries.  

What other similarities or differences does the generation-skipping trust have with revocable and irrevocable trusts? Here’s a quick look:  

Comparison of GST vs Irrevocable vs Revocable Trust 

Investors are advised to take note of which persons or entities take possession and hold title of assets in each type of trust. That way, they can decide which trusts to use based on key factors like who gets to possess and control the assets. For instance, in a GST, the grantor’s children can get income from the assets, but they don’t own the assets – the grandchildren do. Investors should ask themselves which one of these fiduciary agreements fits their and their beneficiaries’ needs best.  

Generation-skipping trusts pros and cons 

As with the other types of trusts, generation-skipping trusts have their share of benefits and drawbacks. Here are the pros and cons of this sort of trust:  

The pros of generation-skipping trusts 

This type of trust has a number of advantages, especially in preserving wealth and saving on taxes: 

• a generation-skipping trust may save money on taxes that the grantor’s children (second generation) may have had to pay if they were the beneficiaries.  
• the trust is not limited to handing down assets to grandchildren; nieces, nephews, grandnieces, grandnephews, or anyone 37½ years younger than the grantor (excluding spouses or ex-spouses) can inherit.  
• trusts like this one may be used to keep assets safe from lawsuits, bankruptcy and divorce settlements 

The cons of generation-skipping trusts 

Generation-skipping trusts have several restrictions: 

• generation-skipping trusts can cost a lot of money to set up; grantors may need to hire the best estate planning lawyer to make a proper trust, especially for those with large estates  
• money withdrawn from a trust can only be used for living expenses. While the amounts can be generous, it will depend on the size of the estate. Plus, the money may not be sufficient for the beneficiaries’ living standards 
• beneficiaries may not be able to withdraw large amounts in case of an emergency 
• this type of trust is also an irrevocable trust, so no one can change or revoke it 
• the children of the grantor, the “skipped generation,” may resent not owning the assets
• since the trust owns the assets, beneficiaries can only receive income but cannot sell the assets  
• keeping a trustee, which a generation-skipping trust requires, is a continuing expense 
• major changes are expected for generation-skipping trust tax exemption amounts after 2026  

How is a generation skipping trust taxed?  

Tax rules apply only to asset transfers to recipients, usually grandchildren, who are two or more generations younger than the grantor. Transfers to the grantor’s children are not deemed as generation-skipping.  

Assets transferred to a grandchild whose parent (the grantor’s child) is deceased are exempt from generation-skipping trust tax. This tax is levied in addition to the estate tax.  

How is tax calculated for generation-skipping trusts?  

The tax is currently calculated at a flat rate of 40% (the same as the estate and gift tax rate) on transfers above the lifetime generation-skipping trust tax exemption amount of $13.61 million per individual in 2024.  

The exemption amount will grow each year to account for inflation all the way through 2025, but the exemption amount is expected to revert to around $7 million in 2026, again indexed for inflation. 

The generation-skipping trust tax rate applies to outright transfers of property and certain other transfers of property to a trust. Trust income or a principal amount distributed to grandchildren are likewise subject to this tax. 

What is the estate tax exemption amount for a generation-skipping trust?  

Over the years, this amount has varied and is shared by the estate tax and gift tax exemptions. Here’s a historical look at the GST tax amounts:  

You may notice the significant increase in the tax exemption for 2018. In December 2017, President Donald Trump signed the Tax Cuts and Jobs Act (TCJA) that increased the tax exemption.  

Beginning January 1, 2018, the TCJA doubled the estate tax exemption to $11.2 million for single filers and $22.4 million for married couples. This rate only applies from 2018 to 2025. The exemption is indexed for inflation and the 40% top tax rate remains in place. 

The TCJA expires on January 1, 2026, and the exemptions will return to their pre-TCJA amounts unless Congress votes to extend them. 

This video offers some generation-skipping trust examples and simple explanations of how the tax works. They also provide workarounds that can help investors avoid the generation-skipping trust tax.  

How can you use the lifetime exemption from generation-skipping trust tax? 

Depending on the size of the estate, grantors can apply any combination of transfers during their lifetime or even after their passing. There are two possible strategies to use when using the lifetime GST tax exemption.  

• during the lifetime of the grantor – a grantor can gift up to $13.61 million in assets to a trust. The trust will eventually distribute the assets to the grandchildren, preserving wealth and continuing to grow to provide income for future generations.  
• upon the death of the grantor – a grantor can also leave up to $13.61 million in lifetime trusts for their children. When the children pass on, the $13.61 million in the trust (along with any appreciation) passes to the grantor’s grandchildren and will still be exempt from generation-skipping trust tax or estate tax. 

The federal estate, gift and generation-skipping trust tax exemptions are unified and indexed for inflation in future years. As for estate taxes, the unused exemption of the first spouse to pass away can be added to the tax exemption of the surviving spouse. However, the same flexibility does not apply to the generation-skipping trust exemption – any unused exemption upon the grantor’s death is lost. 

What is the generation-skipping transfer tax (GSTT) and what triggers it?  

This is a tax that is levied on a grantor who gifts assets to what’s called a “skip person” either within their lifetime or upon death. A “skip person” is at least two generations younger than the grantor.  

This usually pertains to the grantor’s grandchildren or great-grandchildren who are often the beneficiaries of a generation-skipping trust.  

The generation-skipping transfer tax (GSTT) was meant to prevent wealthy families from avoiding estate taxes. In the past, they could do this by directly transferring or gifting assets to grandchildren or great-grandchildren. 

The GSTT works as an additional tax on any asset or property transfer that skips a generation. This tax is imposed only if the transfer avoids a gift or estate tax at each generation. To make up for the avoided taxes, the IRS levies a second layer of taxes on gifts and inheritances that are over the lifetime gift and estate tax exclusion.  

GSTT is payable only when a beneficiary inherits or receives amounts that are more than the GST estate tax credit.  

How much GSTT would a grantor/transferor pay?  

Decades ago, the GSTT ranged from a hefty 35% - 77%. The current GSTT rate is a flat and relatively more reasonable 40%. This rate has been in effect since 2014.  

When the Tax Cuts and Jobs Act was passed, the number of estates that could be affected by the GSTT was lessened.  

The most significant GSTT exemption in recent years were:  

• $12.06 million for individual tax filers in 2022 and $12.92 million in 2023 
•  married couples received a $24.12 million exemption in 2022 and $25.84 million in 2023 

These were more than twice the pre-act limits of $5.49 million for individuals. 

With these exemption thresholds, most beneficiaries of generation-skipping trusts will avoid the GSTT as the thresholds are extremely high. Also, it’s unusual for them to inherit amounts over $12 million or $13.61 million for 2024.  

Thanks to recent changes to the taxes on generation-skipping trusts introduced by the TCJA, many high-net-worth individuals won't have to worry about paying burdensome GST taxes. Even after the TCJA elapses, the $7 million generation-skipping trust exemption threshold will likely allow many investors to avoid GST taxes. 

Still, wealthy investors should consult estate planning attorneys and financial planners to assist in this aspect of estate planning and ensure their heirs inherit the lion’s share of their assets. Investors may also be surprised to know that some assets are best passed to the third generation.  

Finally, although estate planning has an element of morbidity to it, it is an issue that must be seriously discussed and prepared for.  

Don’t forget to bookmark our page on retirement planning and get more advice on financial topics straight from the experts – right here on InvestmentNews.