This is the follow-up to the last posting on portability If you wish to preserve your wealth for generations to come, you’ll need to leverage your generation-skipping transfer (GST) tax exemption. Like the estate and gift tax exemption, the GST tax exemption stands at an inflation-adjusted $5.25 million, thanks to the American Taxpayer Relief Act of 2012 (ATRA). To ensure that your GST tax exemption goes as far as possible, it’s important to allocate it wisely. ATRA made permanent several GST tax-related provisions, including the automatic allocation rules. Understanding these rules — and when to opt out — will help you focus your exemption where it will do the most good. How the GST tax works 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 estate and gift taxes, at the highest marginal estate tax rate (currently 40%) — to:
  • Direct skips — outright gifts or bequests to a grandchild or another skip person, or transfers to a trust whose beneficial interests are held only by skip persons,
  • Taxable trust terminations — for example, when a child with a life interest in a trust dies, causing the trust assets to pass to a skip person, and
  • Taxable trust distributions — distributions (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 a 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. Allocating your exemption If your generation-skipping gifts won’t exceed the $5.25 million exemption amount, then allocation isn’t an issue. But if you don’t have enough exemption to go around, you should allocate it in a way that maximizes the tax savings. The most powerful tool for leveraging the exemption is an irrevocable trust. You need to allocate only enough of your exemption to cover your contributions to the trust and any future growth will be shielded from GST taxes. Suppose, for example, that you transfer $5 million to a trust for the benefit of your grandchildren and allocate $5 million of your GST exemption to the trust. If the trust’s value grows to $20 million over the next 20 years, the entire amount will be exempt from GST taxes. 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. These 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. Creating a dynasty With careful planning, you can create a “dynasty trust.” By leveraging your GST tax exemption, a dynasty trust can grow and compound tax-free for decades to benefit your grandchildren and future generations.