Four generation-skipping strategies
By Alan G. Orlowsky, J.D., C.P.A.
The federal government will take a hefty percentage of the wealth you pass on to your children upon your death. Then the government will take another big chunk of the wealth that your children pass on to their children. The combined tax rate can exceed 75 percent of your estate over the next two generations!
Before 1986, you could have left assets directly to your grandchildren and skipped a round of estate tax, saving potentially hundreds of thousands of dollars. But Congress closed that loophole when it enacted the Generation-Skipping Transfer (GST) Tax. Now if you leave assets directly to your grandchildren (or give annual gifts to your grandchildren in excess of $13,000 each), your estate must pay a flat 45% GST tax on the transfer. That is in addition to the applicable estate tax or gift tax, which can reach as high as 45% on transfers greater than $3,500,000 in the year 2009.
Congress did grant an exemption along with the 1986 law, to make the GST tax a bit less revolting. You can now exempt $3,500,000 (adjusted each year for inflation) in estate assets from the GST tax. For married couples the exemption is $7,000,000.
There are four basic ways to reduce or eliminate the amount of GST tax on transfers to your grandchildren (and to your great-grandchildren if you should be so lucky): gift-tax exemptions, college tuition and medical expense payments, GST trusts, and “dynasty” life insurance trusts.
The easiest way to reduce GST tax is to take advantage of the annual and lifetime gift-tax exclusions. The annual exclusion lets you give gifts of up to $13,000 per year ($26,000 for a married couple) to each grandchild (or to any other individual), without incurring gift tax. The lifetime gift-tax exclusion is currently $1,000,000, and you can divvy this up any way you like among children, grandchildren, or anyone else. Those transfers are exempt from both gift and GST tax.
Not only does this approach reduce the value of your taxable estate, but you will enjoy the gratitude of your loved ones while you’re still alive.
The second strategy is to pay all or part of your grandchildren’s tuition or medical expenses. Such payments are exempt from gift and GST taxes. One advantage to this approach is that you can use the payments as incentives for grandchildren to attend college, trade school, or other educational institution; or use the funds as incentives for grandchildren to quit smoking, join a fitness program, or wear a bicycle helmet, for example.
The third method is to establish a GST gift trust for each of your grandchildren, and contribute an aggregated total of $4,000,000 (year 2008 dollars) to the trusts. By the time your grandchildren receive the assets in these trusts, or upon the death of your children, their value may have grown dramatically thanks to the accumulation of interest and dividends. Yet your grandchildren will inherit the assets entirely free of estate tax and GST tax.
You can write the trust documents in such a way that your children will be able to use the trust funds (including principal, interest and dividends) during their lifetime. And when they die, the remaining assets in the trusts will pass to their children (your grandchildren) free of estate and GST taxes.
Also, in most cases, funds that you contribute to the trusts are protected from creditors, bankruptcy courts, and estranged ex-inlaws. Here’s a hypothetical comparison to demonstrate how dramatic the tax savings can be. In the first case, Fred and Ethel die with a net estate (after estate taxes) of $4,000,000, and they do not have a GST trust. The estate assets are divided equally among their four children, so that they each receive $1,000,000. The youngest child, Freddy Jr., is a rotten money manager, and he loses much of the inheritance through bad investments and a messy divorce. When Freddy dies 25 years later, his estate is paltry and his children’s inheritance is nil (luckily they’re smart, healthy, industrious kids). Fred and Ethel’s three oldest children, on the other hand, each do well financially so that are able to pass their original inheritance on to their children. But that original $1,000,000 inheritance in each instance has grown over 25 years at roughly an 8 percent compounded annual rate of return, to $6,800,000! The third generation must now pay estate tax again on the $6.8 million.
Let’s look at what might have happened if Fred and Ethel had been smart enough to establish a GST trust for each of their four children, and each trust is funded with $1,000,000. When Fred and Ethel die, no estate taxes are due on those particular trust assets. The three oldest children let the assets grow over 25 years to $6,800,000 and pass them along to the third generation free of estate and GST taxes. The tax savings in that case would reach up to $3 million each — or $9 million in the aggregate!
Fred and Ethel Version 2.0 were very astute — they knew Freddy Jr. was a poor money manager, and they created Freddy’s trust in such a way that he could withdraw the trust income but not the principal during his lifetime. So when Freddy dies, his children inherit the original principal in the amount of $1,000,000. When Freddy’s older siblings die, then $6.8 million is transferred tax-free to each of their children. These hypothetical cases are a bit over-simplified, and the calculations in an actual case can be quite complex. But the magnitude of the savings illustrated here is realistic.
A more sophisticated strategy is to leverage the GST exemption through the use of a particular kind of life insurance trust, which I call a dynasty life insurance trust. This involves insuring the lives of you and your spouse (or you alone if you are a single grandparent), holding the insurance policy in a trust, naming your grandchildren as the beneficiaries, and contributing money to the trust each year to pay the premiums on the policy.
The underlying principal is that the IRS considers the yearly contributions as gifts to your grandchildren, subject to both gift tax and GST tax. When you die, however, the insurance proceeds are not considered gifts, and so the proceeds — which will probably be substantially more than the cumulative premiums paid — go to your grandchildren free of both GST and estate tax.
Let´s see how Ricky and Lucy (neighbors of Fred and Ethel) employ the dynasty trust to benefit their two grandchildren. Ricky and Lucy buy $4,000,000 in joint-survivor life insurance, hold the policy in a trust, and name their grandchildren as beneficiaries of the trust. Let’s suppose the annual premiums are $48,000 — the actual amount will vary according to the age and health of the insureds. Ricky and Lucy therefore contribute $48,000 a year to the trust so that the premiums can be paid. That $48,000 is considered a gift, but it’s not subject to gift tax or GST tax because of the $13,000 annual exclusion per spouse for each beneficiary. In addition, Ricky and Lucy are free to allocate their $7,000,000 GST exemption for the benefit of other heirs.
After the death of both Ricky and Lucy, their grandchildren collect the insurance proceeds of $4,000,000 free of estate and GST tax. If Ricky and Lucy had merely given their grandchildren an outright gift of $4,000,000, there would have been a 45 percent GST tax on $4,000,000 of it, which equals a tax liability of $1,800,000 — plus the applicable gift tax. Plus they would have consumed their entire GST exemption so that they could not have allocated it to other heirs.
You don’t have to be super-rich to benefit from any or all of these generation-skipping strategies. If used properly, they can benefit modestly wealthy families as well. Because the rules governing GST and dynasty trusts can become quite complex, it’s important to get advice from knowledgeable financial and legal advisers. If you have grandchildren, don’t wait too long to plan your generation-skipping strategies, because your options may narrow as you get older.
Alan G. Orlowsky, President of Orlowsky & Wilson, Ltd. in Lincolnshire, Illinois, has been counseling people on estate planning for 28 years. He previously worked for the IRS in its Estate and Gift Tax Division. He also worked for the Deloitte & Touche accounting firm, and he has taught taxation and accounting at Loyola University of Chicago, School of Business.
Al is a contributing author of the book 21st Century Wealth (Esperti Peterson Institute, Denver, 2000), and has written numerous articles on the subject of estate planning. Contact Alan Orlowsky by email or call 847-325-5559.