Financial Advice for Retirement, Social Security, IRAs and Estate Planning

How to Avoid Tax while Helping Grandkids

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Most people are concerned about the financial futures of their grandchildren and even great-grandchildren- more so than the security of their own children. After ensuring their own retirement years are secure, many people tell survey takers the security of the third and fourth generations is their next worry. Apparently they believe their children can take care of themselves or have been helped enough, but worry how their grandchildren will have better lives.

Unfortunately, the tax law creates an impediment to providing significant direct support to grandchildren. Congress decided to discourage people from helping directly their grandchildren. The impediment is known as the generation skipping transfer tax (GSTT) or generation skipping tax.

The GSTT is based on the simple ideas that the government receives its share from every estate and doesn’t wait for it.

In the normal course of events, your estate is left to your children, and they leave their estates (including what is left from yours) to their children. Estate or gift taxes are imposed each time the wealth is transferred. Without the GSTT, if you leave a significant part of your estate to the grandchildren (or give it to them now), the government would lose the estate taxes that would be imposed on that property as it passed through your children’s estates.

Congress created the GSTT to avoid losing that level of estate and gift taxes on direct gifts to grandchildren.

The good news is that each person has a $1 million lifetime GSTT exemption. This exemption is separate from the lifetime estate and gift tax exemption. But the GSTT is complicated. It can trap many who mistakenly think it does not apply to them or are not careful in their planning.

Under the GSTT, any person who is at least two generations younger than you is a “skip person.” A gift or bequest to a skip person is hit with the top estate tax rate (currently 46%) once the lifetime exemption is exhausted.

The GSTT is in addition to regular gift and estate taxes, making it possible that extremely high taxes will be imposed on transfers to skip persons. There is an exception to the GSTT when the parent of the recipient is deceased. In other words, the grandchildren can receive a bequest directly from the grandparents without triggering the GSTT if the grandchild’s parents are deceased.

The GSTT is imposed on a wider array of transfers than most people anticipate.

Gifts and bequests to trusts can trigger the GSTT if the trust beneficiaries are skip persons. The GSTT also is imposed to any transfer for the benefit of a skip person. This provision is very broad. A standard family planning trust might trigger the GSTT. For example, assets often are protected for the grandchildren by leaving property to a trust. If the children (the grandchildren’s parents) do not receive income and principal from the trust, the GSTT could be triggered when the trust is created or property is transferred to it. An experienced estate planner must be consulted to ensure a multi-generation trust will not cause the GSTT to be imposed.

While the GSTT can be complicated, a good general rule is that if the property is taxable in the child’s estate, then the GSTT does not apply. Otherwise, the GSTT might be due or part of the lifetime GSTT exemption might be used.

Because of the $1 million exemption, many people assume they do not need to worry about the GSTT. That can be a dangerous assumption. The exemption is a cumulative lifetime exemption that includes all gifts made in prior years. A person might have made numerous gifts to a grandchild over the years. Then, a trust created as part of the estate could put the person over the exemption amount and trigger the GSTT. Even a fairly modest estate can incur a large generation skipping tax bill.

It might be less expensive to avoid the GSTT by leaving assets to children instead of grandchildren. The GSTT is avoided for assets that are included in the children’s estates (the grandchildren’s parents). The assets do not have to be taxable in those estates to avoid the GSTT. The lifetime estate tax exemptions of the children, for example, could shield the assets from taxation, so the assets eventually are transferred to the grandchildren without being depleted by another layer of estate taxes. The main reasons not to leave assets directly to the children are a concern that they would waste the assets, their creditors would eventually get the assets, or they already have large estates.

Like other provisions of the estate tax, the GSTT is scheduled to expire for 2010 and be reimposed in 2011 and later years if Congress does not take action.

The GSTT is complicated. You must rely on an estate planner for the details of how to navigate around it. But you need to be aware of the GSTT and verify that your estate planner has considered the GSTT and found a way to avoid it.

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