Generation Skipping Transfer Tax

If some or all of your estate bypasses your children and goes directly to a grandchild, there could be another tax called the generation skipping transfer tax (GSTT). This can happen intentionally, if you "skip" the living parent (your child) and leave an inheritance directly to your grandchildren.

It can also happen unintentionally. For example, if the inheritance is in a trust for your child, he or she dies after you but before receiving the full amount and, under the terms of the trust, your grandchildren will receive their parent's remaining inheritance, it could then be subject to the GST tax.

Why do we have this tax? Well, in the past, generation skipping trusts were common, especially among the wealthy. The grandfather would set up a trust that distributed only income (no principal) to his children. The trust principal would be distributed later to his grandchildren and future generations.

This allowed the trust assets to grow tax-free and appreciate in value. And it avoided the heavy taxation that would have occurred if each generation had been taxed on the full inheritance. The Rockefellers are one family who used this concept to great advantage, building (and retaining) considerable wealth for several generations.

Eventually, of course, Uncle Sam decided he wanted his share of taxes, just as if each generation had received its inheritance and paid taxes on it. So, if you leave substantial assets to your grandchildren and future generations - bypassing your children's generation - these assets may be subject to the generation skipping transfer tax. (This tax also applies if you leave assets to a non-relative who is more than 37 1/2 years younger than you.)

The bad news is that this is a very expensive tax. It is equal to the highest federal estate tax rate in effect at the time. In 2013, the top rate is 55%. And the GST tax is in addition to the federal estate tax!

So if, for example, $10 million of a $15 million estate was left directly to the grandchildren in 2013 with no estate planning, $5.5 million (55% of $10 million) would be paid in estate taxes. Another $2,475,000 (55% of the remaining $4.5 million) would be paid in GST taxes. The grandchildren would only receive $2,025,000--a little more than one-fourth of their $10 million inheritance.

Now the good news is that most people won't be affected by the GST tax--because everyone has an exemption from this tax. In 2013, the GST exemption is $1,400,000. So, in 2013 you and your spouse together can leave up to $2,800,000 to your grandchildren and future generations without having to pay the generation skipping transfer tax. But just like the federal estate tax exemption, you have to plan ahead so you don't waste one of these GST tax exemptions.

One way is with the A-B-C living trust (as explained in Part Three of "Understanding Living Trusts®"). When one spouse dies, the estate can be divided in half. The deceased spouse's $1.4 million GST tax exemption in 2013 can be applied to his/her half (Trust B Trust C). And when the surviving spouse dies, his/her GST tax exemption can be applied to Trust A. This makes full use of both exemptions. Your attorney, of course, may suggest other planning options.