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Skipping the Generation-Skipping Transfer Tax

If your gifts or estate exceeds the federal estate tax exemption, the IRS could keep up to 40% of the excess that would otherwise go to your heirs. That’s doubly true if you give assets directly to your grandchildren—or anyone else who’s at least 37.5 years younger than you. That’s because of the so-called generation-skipping transfer tax (GSTT), which in 2019 is an additional 40%—on top of the estate tax.

Why are assets that skip a generation taxed differently? Because the IRS wants to collect its share as wealth passes from each generation to the next. So when assets are transferred directly to, say, grandchildren, the IRS imposes the GSTT to make up for the difference it would have collected had the assets passed to the children and then the grandchildren.

“In cases like this, your estate’s biggest beneficiary could end up being the U.S. Treasury rather than your grandchildren,” says James Madden, a Schwab wealth strategist based in Phoenix.

To be sure, the GSTT affects only the largest estates, particularly since the federal estate tax exemption was doubled in 2017. Even so, nearly 2,000 estates paid a total of $14.93 billion in federal estate taxes in 2018, according to the nonpartisan Tax Policy Center.

How much of that was because of the GSTT is anybody’s guess. But if you have a large estate and plan to leave at least part of it to your grandchildren, it pays to understand how the tax works and how trusts can be used to help minimize the tax hit.
 

The tax trap

According to Hayden Adams, CPA and director of tax and financial planning at the Schwab Center for Financial Research, there are several ways to transfer assets to someone without getting hit with gift, estate or generation-skipping transfer taxes:

  • Throughout your life, you can use the annual gift tax exclusion to give up to $15,000 per person (as of 2019) to as many people as you like without eating into your lifetime federal gift, estate and generation-skipping transfer tax exemption.
  • You can also make direct payments to certain education and health care providers for qualified tuition and medical expenses on behalf of someone else without affecting your lifetime federal gift, estate and generation-skipping transfer tax exemption or your $15,000 annual gift tax exclusion.
  • As of 2019, you can gift or bequeath up to $11.4 million tax-free to the next generation—or anyone else who’s up to 37.5 years younger than you—after which the 40% gift and estate tax generally kicks in.
  • Alternatively, you can gift or bequeath up to $11.4 million tax-free to grandchildren—or anyone else who’s 37.5 years (or more) younger than you—after which the 40% gift and estate tax and 40% GSTT generally kick in.

The $11.4 million exemption is actually two separate exemptions—one for gifts and estates, the other for the GSTT—however, when you use a portion of one exemption, an equal amount is automatically subtracted from the other.

Here’s an example of how these taxes and exemptions work. Imagine you wanted to make direct gifts of $7.7 million each to your adult daughter and grandson, for a total of $15.4 million. The most tax-efficient way to do this would be to apply the GSTT exemption to the grandson’s $7.7 million gift, thereby avoiding both the 40% gift and estate tax and the 40% GSTT.

That would reduce your remaining exemption to $3.7 million, which you could use to cover a portion of your daughter’s gift. The remainder of that gift—$4 million—would then be subject to just the 40% gift and estate tax.

The GSTT may not seem like much of an issue for most estates, but the lifetime federal estate tax exemption could be cut roughly in half (adjusted for inflation) come 2026, unless Congress acts before then to extend the provision—meaning many more estates could face the GSTT at some point in the future. “Dramatic changes to tax policy are always possible, depending on the outcome of any given election, so it pays to think far into the future when creating your estate plan,” Hayden says.
 

The trust solution

“If you’re likely to face the GSTT, it can help to talk with a financial advisor about strategies, which can include gifting assets while alive and/or making charitable contributions in order to remain within the federal estate tax exemption,” James says.

Another potential solution is to set up a specialized trust.

One such trust is a generation-skipping trust, in which assets are subject to the estate tax only once: when they’re transferred to the trust. Any cash, investments or property must remain in the trust as long as the skipped generation is alive; however, the assets will pass tax-free to the subsequent generation once the skipped generation has passed on. In the meantime, any income generated by the trust can be enjoyed by both the skipped generation and/or the subsequent generation, depending on the terms of the trust. Such trusts can also protect against claims by creditors of the estate.

A similar trust, called a dynasty trust, functions like a generation-skipping trust, only it can be extended indefinitely to subsequent generations. As with a generation-skipping trust, the beneficiaries of a dynasty trust can enjoy the income from the trust; however, they never gain control over the assets themselves.

Setting up a generation-skipping or dynasty trust involves careful consideration. Once a grantor transfers assets to the trust, for example, he or she no longer controls them, and it’s irrevocable, meaning the grantor can’t claw the assets back once they have been placed in the trust. This can become an issue should a recession or other setback eat into the funds needed to maintain the grantor’s retirement.

Be that as it may, generation-skipping and dynasty trusts can help estate holders avoid being taxed more than once as assets pass from generation to generation.

What You Can Do Next

  • Read more tax and estate-planning tips.

  • Interested in having your generation-skipping or dynasty trust managed by a professional? Call 877-862-4304 to see how Schwab Personal Trust Services can help.

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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, you should consult with a qualified tax advisor, CPA, financial planner or investment manager.

Charles Schwab & Co., Inc. (“Schwab”) is affiliated with Charles Schwab Trust Company (“CSTC”), the corporate trustee for Schwab Personal Trust Services (“SPTS”).

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