Protect Against The 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 imposed 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.

In the past, generation skipping trusts were common, especially among the very wealthy. Granddad 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 2003, the top rate is 49%. And the GST tax is added on top of the federal estate tax!

If, for example, $10 million of a $15 million estate was left directly to the grandchildren in 2003 with no estate planning, $4.9 million (49% of $10 million) would be paid in estate taxes. Another $2,499,000 (49% of the remaining $5.1 million) would be paid in GST taxes. The grandchildren would only receive $2,601,000--about one-fourth of their $10 million inheritance.

The good news is that most people won't be affected by the GST tax, because everyone has an exemption from this tax. This means that in 2003, the GSTT exemption is $1,120,000. So, in 2003 you and your spouse together can leave up to $2,240,000 to your grandchildren and future generations without having to pay the generation skipping transfer tax. But just like the federal estate tax exclusion amount, 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. When one spouse dies, the estate can be divided in half. The deceased spouse's $1,100,000 GST tax exemption 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.

NOTE: This information is designed to provide a general overview with regard to the subject matter covered and is not state-specific. The authors, publisher and host are not providing legal, accounting or any other advice which purports to be specific to your situation. The contents of this website are believed to be completely reliable. Nevertheless, some material may be affected by changes in the laws or interpretations of such changes since the material was entered on the website. If legal advice or other expert guidance is required, the services of a competent professional in the field of law, accounting, insurance or investments should be sought.

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