How Do Generation Skipping Trusts Work?
Generation skipping trusts (GSTs) are an estate planning tool that transfers assets to grandchildren, great-grandchildren, or individuals at least 37.5 years younger than the grantor. It is structured to bypass estate taxes that may apply if assets pass through each generation.1 Here's an overview of how they work:
- Create the Trust: The grantor works with an estate planning attorney to draft the trust document. It outlines the trustee’s powers, beneficiaries, and distribution terms under generation skipping trust rules.
- Fund the Trust: The grantor transfers assets into the trust. These may include cash, stocks, bonds, real estate, or other investments.
- Appoint a Trustee: The grantor appoints a trustee responsible for managing the trust's assets and overseeing distributions according to the trust's terms. This trustee can be an individual, a group of individuals, or a corporate entity, like a bank or a trust company.
- Designate Beneficiaries and Set Terms: Beneficiaries are often grandchildren or later generations. The grantor sets when and how funds may be distributed, such as at a certain age or for education, a home purchase, or starting a business.
- Understand the Generation Skipping Transfer Tax (GSTT): The U.S. imposes a generation skipping transfer tax (GSTT) on transfers to individuals two or more generations below the grantor. A GST exemption allows a certain amount to pass without this tax. The exemption is adjusted for inflation. Amounts above the exemption may be subject to GSTT, separate from estate or gift taxes.
- Make Distributions: Distributions follow the trust terms. Funds may be used for living expenses, education, emergencies, or other purposes allowed under the trustee’s discretion.
- Determine Duration: A GST can last for multiple generations, depending on state law. Some states limit how long a trust may exist under rules against perpetuities. Others allow long-term or indefinite trusts, sometimes called dynasty trust.
- Terminate the Trust: The trust ends when assets are depleted, the last beneficiary dies, a set time period expires, or state law requires termination. Remaining assets are distributed according to the trust agreement.
Consult an estate planning attorney and financial advisor to review the implications, costs, and benefits of a generation skipping trust.
What Are the Benefits (Pros) Of a Generation Skipping Trust?
A generation skipping trust (GST) can offer tax advantages, asset protection, and greater control over how wealth is passed down. Below are the main benefits:
Estate Tax Reduction or Elimination
Assets passed directly to children and then to grandchildren are typically taxed at each transfer. Over time, this can reduce the value of an estate.
A generation skipping trust allows assets to skip a generation, which may reduce or eliminate estate taxes at each level and help preserve more wealth for future beneficiaries.
Generation Skipping Transfer Tax Exemption
The generation skipping transfer tax (GSTT) applies to assets that skip a generation. However, there is a federal exemption that allows a certain amount of assets to be transferred into a generation skipping trust without triggering this tax.
This exemption is adjusted periodically for inflation and can be used strategically to transfer wealth.
Protection of Assets
Assets held in a generation skipping trust are generally not owned outright by the beneficiaries. As a result, they may be protected from:
- Creditors
- Legal judgments
- Divorce settlements
This structure can help keep family wealth within the family.
Control Over Wealth Distribution
The grantor can set clear terms for how assets are managed and distributed. For example, distributions can be tied to:
- Reaching a certain age
- Graduating from college
- Specific life milestones
- Health needs or financial hardship
This allows the grantor to direct how and when beneficiaries receive funds.
Long-Term Wealth Management
Some states allow trusts to last for many years, and in certain cases, indefinitely. These are often referred to as dynasty trusts.
Assets can be professionally managed by a trustee or trust company, providing long-term oversight for multiple generations.
Privacy
Trust assets and terms are generally not part of the public record. This can help families keep financial matters private.
Flexibility
A generation skipping trust can be structured to accommodate:
- Different types of assets
- Changing beneficiary circumstances
- Multiple generations of heirs
This flexibility allows the trust to adapt to long-term family goals.
A generation skipping trust helps protect family wealth for future generations. Start Your Free Plan
What Are the Potential Drawbacks (Cons) of a Generation Skipping Trust?
Before setting up a generation skipping trust, consider the following challenges.
Complexity and Cost
Establishing a generation skipping trust can be complex. It often requires guidance from an estate planning attorney and a financial advisor. In addition to the initial setup, ongoing administration may involve accounting services, legal fees, and trustee fees. Over time, these costs can become significant.
Irrevocability
Many generation skipping trusts are irrevocable. Once the trust is created and funded, the grantor typically cannot change the terms or reclaim the assets. This limited flexibility may create challenges if family circumstances or laws change.
Downside of Generation Skipping Transfer Tax (GSTT)
The United States provides a large exemption from the generation skipping transfer tax. However, transfers that exceed the exemption amount may be subject to a high tax rate. If the trust is not structured properly, this tax could reduce the intended benefits.
Potential Family Conflict
Skipping a generation may lead to tension within a family. Children whose inheritance passes directly to their own children may feel overlooked. Even if they receive income from the trust, they may have no control over the principal, which can create disagreements.
Beneficiary Preparedness
Younger beneficiaries may not be ready to manage inherited assets. Although the trust can control how and when distributions are made, some beneficiaries may rely on future wealth instead of developing financial independence or professional skills.
Changing Laws and Regulations
Estate and tax laws can change over time. Future updates may affect how a generation skipping trust is taxed or administered, which could reduce its effectiveness.
Duration Limits
Some states follow the Rule Against Perpetuities, which limits how long a trust can remain in effect. If the trust must terminate earlier than intended, it may trigger tax consequences and disrupt long-term plans.
Carefully weigh these drawbacks against the potential benefits. Consult an estate planning attorney and financial advisor to determine whether a generation skipping trust aligns with your goals and circumstances.
How Much Does a Generation Skipping Trust Cost?
Setting up a generation skipping trust (GST) involves several types of costs. The total amount depends on the size of the estate, the assets involved, the attorney’s fees, and state laws. While it's challenging to provide a precise cost without specific details, let's explore the general financial components:
- Attorney's Fees: Often start at a few thousand dollars for a simple generation skipping trust. Costs can rise if the estate includes multiple assets, complex investments, or detailed family needs.
- Trustee Fees: Banks and professional trustees usually charge a percentage of the trust’s assets. Fees vary based on asset complexity and services provided. Individual trustees may charge less but can still receive compensation and reimbursement for expenses.
- Administrative Costs: May include filing fees and the cost of preparing and submitting trust tax returns. Larger or more complex estates may also require accounting support.
- Asset Management Fees: Investment advisory fees apply if assets are actively managed. Property management fees may apply if the trust holds real estate.
- Ongoing Operational Costs: Distributing income and maintaining accurate records can create added expenses, especially when professional services are used.
Because costs vary widely, it is important to request detailed estimates from attorneys, trustees, and other professionals before establishing a generation skipping trust.
How Are Generation Skipping Trusts Taxed?
The taxation of a generation skipping trust can be complex. It may involve federal and state tax rules. Below is a breakdown of the main taxes that may apply.
Generation Skipping Transfer Tax (GSTT)
The generation skipping transfer tax is a federal tax on assets transferred to beneficiaries who are two or more generations below the grantor, such as grandchildren or great grandchildren. The GSTT is imposed at a flat rate equal to the highest federal estate tax rate. This rate can change under current tax law.
Each individual has a lifetime GSTT exemption. This is the amount that can pass to skip persons without triggering the tax. The exemption is linked to the federal estate and gift tax exemption and may change each year due to inflation adjustments. Any transfers above the exemption amount are subject to the GSTT.
Estate and Gift Taxes
Assets transferred to a generation skipping trust may also be subject to estate or gift taxes.
If assets are transferred during life:
- The transfer is treated as a gift.
- It may be subject to federal gift tax if it exceeds the annual gift tax exclusion.
If assets are transferred at death:
- The transfer may be subject to federal estate tax.
- Estate tax depends on the total value of the estate and the available estate tax exemption.
Income Tax
A generation skipping trust may also be subject to income tax. Any income the trust earns and keeps is taxed at trust income tax rates. Trust tax rates are compressed and reach the highest bracket at lower income levels than individual rates. Distributions to beneficiaries may be taxable to the recipient, depending on the type of income distributed.
State Taxes
State-level taxes may also apply, including:
- Estate tax
- Inheritance tax
- State income tax
State rules vary based on where the grantor lives, where the beneficiaries live, and where the trust is administered.
Remember that tax laws are subject to change. The rules in place when a generation skipping trust is created may not remain the same in future years.
Because these rules can lead to significant tax liability, individuals considering a generation skipping trust should work with qualified estate planning attorneys, tax professionals, and financial advisors. These professionals can help structure the trust in a way that aligns with the grantor’s goals and applicable tax laws.
Is a Generation Skipping Trust Right for You?
Whether a generation skipping trust is worth it depends on your goals, estate size, and family situation. Here is a breakdown to help you evaluate your options.
When a Generation Skipping Trust May Make Sense
| Situation | Why It May Help |
|---|---|
| Large Estates and Tax Benefits | If your estate exceeds federal tax exemption limits, a GST may reduce estate taxes by avoiding taxation at each generational level. |
| Long-Term Wealth Preservation | A trust can be structured to last for years or multiple generations, helping pass assets to grandchildren and beyond. |
| Control Over Distributions | You can set rules for when and how beneficiaries receive funds, such as at a certain age or for specific purposes. |
| Asset Protection | Assets held in the trust are generally not owned directly by beneficiaries. This may help protect them from creditors and legal claims. |
| Complex Family Situations | If a child is unable to manage money or does not need it, the trust can direct assets to grandchildren or future generations instead. |
When a Generation Skipping Trust May Not Be the Best Fit
| Situation | Why It May Not Help |
|---|---|
| Smaller Estates | If your estate is below federal tax exemption limits, the tax benefits may be limited compared to the cost and complexity of creating and maintaining a GST. |
| Immediate Family Needs | If your children have significant financial needs, skipping them may not align with your goals. Another trust structure may be more appropriate. |
| Uncertainty About Beneficiaries | Because these trusts often benefit younger or unborn descendants, it can be difficult to predict their future needs or financial habits. |
| Potential Family Conflict | Skipping one generation could create tension within the family. Emotional considerations are just as important as tax savings. |
| State Law Limitations | Trust laws vary by state. Some jurisdictions limit how long a trust can last or impose higher taxes on trust income. |
A generation skipping trust is not the right solution for every family. Before making a decision, speak with an estate planning attorney and a financial advisor to review the legal, tax, and personal considerations involved.
Final Thoughts
A generation skipping trust can help transfer wealth across generations, but it is not the only trust option available. The right type of trust depends on your finances, family situation, and long term goals. Take time to review your options carefully and work with professionals to create a plan that fits your needs.
A generation skipping trust allows assets to pass to younger generations. Start Your Free Plan
Sources
- Internal Revenue Service Form 706. https://www.irs.gov/instructions/i706.
