A "generation-skipping transfer" refers to passing assets directly to your grandchildren, great-grandchildren or someone else besides your children. These transfers are often accomplished by putting those assets in a generation-skipping trust, and both the transfers and trusts are commonly referred to by the abbreviation GST. Families use generational "skips" for tax savings and other benefits, and they usually involve a financial professional, since the details can get complicated.
Estate Taxes and Trusts
At one time, wealthy families used generation-skipping trusts to avoid estate taxes. Usually, wealth is subject to estate tax when it passes from a person to his children, and then again when it passes from those children to their own children, and so on down the family line. Using a GST to pass wealth directly to grandchildren or great-grandchildren got the family out of paying one or more rounds of estate tax. Now, however, the federal government levies a tax on generation-skipping transfers designed to recover lost estate tax revenue. Even with this tax in place, though, GSTs can provide tax benefits.
The vast majority of estates are too small to incur tax, so no skips involving those estates would be taxed, either. As of the time of publication, the first $5.34 million worth of any estate was untaxed, and that "exemption" amount rises with inflation. But families with more wealth than that can still save money by using a generation-skipping "exempt" trust. They do this by creating a trust for the benefit of grandchildren (or whomever they want to pass wealth to) and placing assets equal to the exemption amount in that trust. Estate tax thus doesn't apply to the trust. Those assets grow over time from investment returns, with the gains going to the grandkids free of estate tax. If the assets had simply passed to the children, then both the assets and the gains would have been subject to estate tax upon the children's death.
A Hedge Against Irresponsibility
It's a reality that some parents worry about whether one or more of their children can be trusted with inherited wealth. Setting up a trust to skip those children and pass wealth farther down the family line can temper some of these concerns. If they choose, the parents can still allow their children to receive income from investments in the trust -- such as stock dividends, bond interest or real estate rents -- but the children don't control those investments or have the power to sell off the trust's assets.
Protection From Creditors
Say you have a child whose profession puts her at a high risk of lawsuits -- a doctor, say, or an engineer or a lawyer. Or maybe the child is an entrepreneur who risks incurring high debt if her business fails. If your wealth passes to that child, it becomes subject to attachment or seizure by creditors, and your family legacy could be drained away. A generation skip keeps assets out of the child's hands, so they can't be grabbed out of that hand, thus preserving the legacy for the next generation.
Passing Wealth Outside the Family
Generation-skipping transfers don't have to move assets to a descendant. The recipient can be anyone, so long as he or she is at least 37 1/2 years younger than the person from whom the wealth will be transferred and was never married to that person. Gifts outside the family are subject to gift tax -- which is actually a provision of the estate tax, with certain gifts directly reducing a person's estate tax exemption. So GSTs can be used to move wealth to non-relatives with the same kind of tax savings.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.