Would you like your grandchildren to end up with only 20% of what you intended? That’s what happens in most cases. The government doesn’t want you to pass wealth directly to your grandchildren. It wants the money to stay in your estate, get it hit by estate taxes, go to your children, get it hit by estate taxes again, then finally trickle down to your grandchildren.
The primary way the government keeps wealth from your grandchildren is the generation-skipping tax. This tax is in addition to the regular estate tax. It imposes a 55% tax rate on property that is bequeathed to someone more than one generation after yours. So property will get hit with your estate tax, then the GST, then the grandchild gets whatever is left.
Fortunately, there are a number of ways around the generation-skipping tax. With some planning, you can skip a generation or more and keep taxes low.
The first exception is the annual tax-free gift amount. Currently, you can give up to $10,000 annually to anyone without incurring any gift taxes. You and your spouse can give $20,000. Also, any gifts or bequests that are covered by the lifetime $650,000 estate and gift tax exemption (which rises to $675,000 on Jan. 1, 2000 and $1,000,000 by 2006) are not subject to the generation-skipping tax.
There also is a $1 million per donor lifetime exemption from the generation-skipping tax. That means you can give a total of up to $1 million total directly to your grandchildren, and your spouse can do the same.
You can pass a powerful amount to your grandchildren using these strategies. Remember that your adult children also will have lifetime exemptions that rise to $1,000,000 by 2006. This means that if you use your exemption to leave $650,000 to your children estate and gift tax free, they can let that money grow and give $1,000,000 tax free to your grandchildren. If you are married and have more than one child, the amount that passes to the grandchildren using these methods can be quite large.
Keep in mind that unlimited gifts can be made for medical and education expenses. You have to make the payments directly to the provider of the goods and services. Medical payments must be made for services that would qualify for itemized deductions. Education expenses can be for direct tuition, not for books, and supplies, or room and board.
Here’s where a new IRS ruling comes in. A grandmother prepaid years of education expenses for her two grandchildren, totaling more than $163,000. The payments were structured so that they were not refundable. The IRS ruled that they qualified for the unlimited tax free education gifts. The IRS ruling was a private ruling, which technically applies only to the taxpayer in that case. But it indicates the IRS’s thinking, and the IRS tries to be consistent over time in its rulings.
If you have exhausted these possibilities and still want to give more, or you don’t want to give outright gifts to your children or grandchildren, then trusts are the next step.
You put money or property in a trust now for the benefit of the grandchildren. Put appreciated property into a trust now and you avoid both estate taxes and the generation-skipping tax on the future appreciation. In fact, there never is another estate, gift or generation-skipping tax on the trust property – no matter how much the trust property appreciates. The only taxes are on income and capital gains. You might owe gift or estate taxes when property initially is placed in the trust, but none should be due after that.
The idea is to limit distributions from the trust in the early years so that it can grow. Then the grandchildren can receive distributions. You set the standards for the amount of the distributions. The total return of the trust might exceed the distributions.
A well-funded, properly-designed, and well-invested trust can last for several generations, becoming a dynasty trust. In most states a trust isn’t allowed to last for more than the lives of individuals living at the trust’s creation plus 21 years. But Delaware, South Dakota, New Jersey, Wisconsin, and Alaska allow trusts to last basically forever.
If you don’t have a lot of money or property to put aside for your grandchildren, consider purchasing some life insurance and having it owned by a trust. You transfer gifts to the trust each year to pay the premiums. Eventually the policy should pay benefits to the trust that are several times the premiums you paid. The policy benefits will be tax free and can be invested for income or growth.
Congress and the IRS don’t want you to leave much for your grandchildren. But with a little planning you can get around all the restrictions and leave significant after-tax wealth for future generations.