Skip, Skip, Skip to My Lou! But What Is a Generation Skipping Trust?
By Kristin Sun, CFP®, CDFA®
October 25, 2022
In the classic Judy Garland movie Meet Me in St. Louis, the children of the Smith family gather with their friends for an evening of revelry, which includes the performance of the catchy tune “Skip to My Lou”. While there were many children in the Smith Family, and though it seems Mr. Alonzo Smith was able to provide a comfortable living for them all, the use of a Generation Skipping Trust (GST)—to skip-skip-skip-a-generation—may not have made sense for their family legacy. But in situations of considerable family wealth, GSTs are an interesting option for wealth transfer and preservation.
A Generation Skipping Trust is an irrevocable trust utilized to transfer significant wealth from the grantors (trust creators) to their grandchildren (or anyone at least 37.5 years younger). Doing so skips their own children, known as the “skip generation”, by passing the wealth directly to the grandchildren. This effectively avoids one cycle of estate taxes. In contrast, if assets pass directly to the next generation, who then pass the assets to their children, the accumulated wealth could be subject to estate taxation at each inheritance level. As an added benefit, while the grantor(s) are alive, they can pay the taxes generated by the GST, effectively removing more assets from their estate, and amplifying their original gift. Additionally, paying these taxes doesn’t prevent them from making the standard annual exclusion gifts each year to the same beneficiaries. For 2022, this amount is $16,000 per person, but for 2023, the IRS has confirmed this amount will increase to $17,000 per person. For the skipped generation, not all is lost: they may access the earnings of the trust assets, just not the original assets that funded the trust.
What about the Generation Skipping Transfer Tax (GSTT)? The GSTT is a 40% flat federal tax that is applied to any transfers where the recipient is more than 37.5 years younger than the gifting party. As it pertains to the funding of Generation Skipping Trusts, any amount above the lifetime exemption would be subject to this tax. In 2022, the lifetime exemption limit is $12.06 million per person. In 2023, it increases to $12.92 million per person. At the end of 2025, the large exemption is set to sunset back to pre-2018 levels, adjusted for inflation. Importantly, the 40% GSTT is in addition to the flat 40% federal estate tax. When imposed together, this equates to a 64% combined tax on assets above the lifetime exemption limit.
GSTs are a valuable estate planning strategy but there are some drawbacks. The use of a GST may not be in the best interest of the skip generation in the event their circumstances change. Since the skip generation can only access the earnings of the GST, this strategy may lead to unintended consequences that may not be immediately clear until later in their lives. If the skipped children eventually come to rely on the financial support of their inheritance, then a GST structure where they can only benefit from earnings may not be adequate to meet that need. Additionally, given that GSTs are irrevocable trusts, there is a likely long-term burden and cost to administer the trust that should be considered.
When used properly, Generation Skipping Trusts can be a very effective tool for multi-generational wealth preservation. But as with any strategy, it is important to assess the benefits and possible pitfalls before including the use of GSTs in your estate plan. If Mr. and Mrs. Smith of St. Louis utilized a GST for their estate, none of their five children would have been able to rely on an inheritance for support (beyond the earnings). If you would like to explore whether a GST makes sense for your family, we encourage you to contact your estate planning attorney and Sand Hill Wealth Manager to discuss.
Source: Internal Revenue Service
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