If you’ve recently become a grandparent, you may be considering making a gift to the newest member of the family. However, before taking action, it’s important to understand how the generation-skipping transfer (GST) tax may affect your estate plan.
GST tax in action
Like the gift and estate tax exemption, the GST tax exemption stands at an inflation-adjusted $5.34 million for 2014. In addition, the GST tax is a flat tax — applied at the highest marginal estate tax rate, currently 40% — on transfers that skip a generation.
GST tax applies to transfers to “skip persons” — that is, grandchildren or other relatives more than one generation below you or nonrelatives more than 37½ years younger than you. (There’s an exception, however, if your child predeceases you. In that case, your grandchildren by that child are no longer considered skip persons.)
The tax applies — in addition to gift and estate taxes — to:
Direct skips. These are an outright gift or bequest to a grandchild or another skip person, or transfers to a trust whose beneficial interests are held only by skip persons.
Taxable trust terminations. An example of a taxable trust termination is when a child with a life interest in a trust dies, causing the trust assets to pass outright to a skip person.
Taxable trust distributions. This type of distribution occurs when a transfer of funds emanates from a trust (other than a direct skip or trust termination) to a skip person.
The GST tax applies only to transfers that are subject to gift or estate tax. So, if you make an outright gift to a grandchild that’s within the annual gift tax exclusion (currently $14,000 per recipient) or a direct payment of qualifying tuition or medical expenses on a grandchild’s behalf, there’s no GST tax.
Leveraging your exemption amount
If your generation-skipping gifts won’t exceed the $5.34 million exemption amount, allocation isn’t an issue. But if you don’t have enough exemption to go around, allocate it in a way that maximizes the tax savings.
A powerful tool for leveraging the exemption is an irrevocable trust. Allocating only enough of your exemption to cover your contributions to the trust will allow any future growth to be shielded from GST taxes — thus creating a “dynasty.”
Considering the automatic allocation
As you plan your estate, pay careful attention to the automatic allocation rules, which automatically allocate your GST tax exemption to direct skips and certain trust contributions. The rules are designed to prevent you from inadvertently losing the benefits of the exemption. But in some cases, it makes sense to opt out.
Say you’re making several outright gifts to your grandchildren but you’re also planning to set up a $5 million trust for their benefit. To save your exemption for the trust (where it will generate the greatest tax savings), you might want to opt out of automatic allocation for the outright gifts.
Playing by the GST tax rules
If you plan to make gifts to your grandchildren or later generations, talk to your estate planning advisor about the GST tax rules. The rules regarding allocation of the GST tax exemption are complex, and mistakes can be costly. Your advisor can also inform you of the ins and outs of the automatic allocation.