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An Intro To Generation-Skipping Transfer Tax

We'll talk about what is the generation skipping tax, gst exemption vs lifetime exemption and real life examples of the generation skipping transfer tax exemption.

Table of contents

Key Takeaways:...Read more

What is Generation-Skipping Tax?...Read more

How much is the GST taxes?...Read more

GST taxes exemptions and exclusions...Read more

Generation-Skipping Tax: real-life examples...Read more

How to avoid GST taxes...Read more

Key Takeaways:

GSTT is federal tax on transfers of assets or property to individuals (or to a trust for their benefit) that are more than one generation below the transferor.
The generation skipping transfer tax is at a flat rate of 40%.
Contributing to 529 plans or creating dynasty trusts can help reduce or avoid GST taxes.

What is Generation-Skipping Tax?

The generation-skipping transfer tax, or GST tax, is a federal tax on gifts or inheritances that are passed directly to grandchildren, skipping their parents. It also applies if the recipient is more than 37½ years younger than the giver. This tax is charged at the highest federal gift and estate tax rate (40% in 2024) and it’s in addition to any other federal gift or estate taxes owed. This tax is to ensure that the same estate taxes apply as if the inheritance had first gone to the parents before reaching the grandchildren. The person giving the gift is called the transferor, and the person receiving it is the skip person. While many people use a grandchild as a skip person, the recipient doesn't have to be a family member. Before GST taxes were introduced in 1976, wealthy individuals could use generation skipping to transfer money and property to their grandchildren without paying federal estate taxes. The law was created to close this loophole and prevent skipping a generation to avoid double estate taxation. The tax applies in a few different scenarios. First, there are direct skips, which occur when assets are transferred directly to a skip person, either immediately or through a trust. In these cases, the GSTT is paid by the giver or their estate at the time of the transfer, based on the value of the assets given. Another situation involves taxable distributions. This happens when an irrevocable trust makes a payment to a skip person, but it’s not classified as a direct skip or a taxable termination. Taxable terminations also occur when an interest in a trust ends, such as when a beneficiary dies or the trust term expires, and there are no remaining beneficiaries who are not skip persons. In this case, the trustee is responsible for paying the GSTT when the interest terminates. Each of these situations ensures that transfers and distributions to skip persons are taxed accordingly.

How much is the GST taxes?

In the past, the generation-skipping tax was really steep, ranging from 35% to 77%. Nowadays, the GST tax rate is set at 40%, a change that’s been in place since 2014. Thanks to the Tax Cuts and Jobs Act, fewer estates are hit by GST taxes. For 2024, you can exempt up to $13.61 million per person (up from $12.92 million in 2023) and $27.22 million for married couples (up from $25.84 million in 2023). That’s more than double the old limit of $5.49 million per person. So, if you give or leave more than $13.61 million to a skip person, you’ll pay the generation-skipping tax only on the amount over that exemption, at a flat rate of 40%. The GST tax kicks in when the gift or property transfer happens, whether it’s before or after the giver’s death. While you’re still alive, you can give gifts directly to the skip person. After you pass away, your will might specify that property goes to a skip person or set up a trust for future distributions. You’ll use Form 709 to report both GST taxes and any federal gift taxes due.

GST taxes exemptions and exclusions

When dealing with the generation-skipping tax, understanding the exemptions can help you save on taxes.

GST exemption vs. lifetime exemption

The GST exemption is a key player in how much you can pass on without facing the generation-skipping tax. For 2024, you can exempt up to $13.61 million per individual, which is a big increase from previous years. This is often referred to as the GST exemption. It’s a specific amount that you can transfer to skip persons, like grandchildren, without triggering the GST tax. It’s important to understand how this fits into the bigger picture. This GST exemption is part of your overall lifetime exemption. The lifetime exemption covers not just the GST tax but also estate and gift taxes. For 2024, the total lifetime exemption is the same as the GST exemption. This means that if you use part of this exemption for gifts or bequests that are subject to GST taxes, it will reduce the amount you can use for other gifts or bequests without incurring estate or gift taxes. Remember, the tax applies only to amounts exceeding the generation skipping transfer tax exemption. So, if you leave or gift more than $13.61 million to a skip person, the excess will be taxed at the GST rate of 40%.

Generation-Skipping Tax: real-life examples

When you allocate the generation-skipping transfer tax exemption to a trust, any future growth of the trust's assets is also protected from GSTT. For example, if you set up a trust in 2024 with $8 million for your grandchildren and uses the GSTT exemption for this transfer, any growth in the trust’s value—say it grows to $15 million—will not face additional GSTT. This means you effectively sheltered $15 million worth of assets using only $8 million of your generation-skipping tax exemption. Say you want to give your grandchild a large gift to help with their future. In 2024, you have a GST exemption of $13.61 million. You decide to make a direct gift of $9 million to your grandchild. The $9 million gift is GST exempt, meaning you won’t have to pay any GST tax on this amount. Even if the gift appreciates in value over time, the additional $3 million in growth will not be subject to GST tax because your initial $9 million gift was covered by your exemption. Imagine you decide to give $10 million to your child and $5 million to your grandchild. Here’s how the exemptions and taxes would play out:

Gift to child: The $10 million gift to your child will use up $10 million of your lifetime gift tax exclusion. Since this amount is covered by your lifetime exclusion, you won’t owe any gift taxes or GSTT on this portion.
Gift to grandchild: The $5 million gift to your grandchild will use up $5 million of your GSTT exemption. Because this amount is covered by your GSTT exemption, the gift is GST tax exempt. In total, you’re using $10 million of your lifetime gift tax exclusion and $5 million of your GSTT exemption. Since both gifts fall within the exemptions, you won’t owe any gift taxes or GSTT. If you had given $20 million to your grandchild instead, you would have used the entire $13.61 million GSTT exemption and faced $2,584,000 in GSTT. This is calculated by subtracting the GSTT exemption from the total gift, which leaves $6.39 million. Multiply that by the 40% GSTT rate to get $2,584,000.

How to avoid GST taxes

Outright gifts, like giving $18,000 from a grandparent to a grandchild, can be simple, but there are other strategies worth considering. For example, grandparents might worry that a grandchild won’t use the money wisely or might want the funds used for specific purposes, like paying for college. One popular method is to contribute to a 529 plan for the grandchild's education. Gifts to a 529 plan are considered completed gifts and are GST tax exempt, even if the grandparent can later change the beneficiary. In 2024, you can use up to 5 years’ worth of annual gift exclusions in one year, allowing you to contribute $90,000 as an individual or $180,000 as a couple without incurring gift tax. Another option is to set up a dynasty trust. This type of irrevocable trust can last indefinitely and provides both asset protection and generation skipping tax benefits. By allocating your generation skipping tax exemption to the trust, you ensure that any transfers into the trust are GST tax exempt. Once the trust is exempt, any distributions or terminations won't trigger additional GST tax, regardless of how much the trust’s assets grow.

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