For many grandparents, it might make sense to get a generation-skipping trust, which is one of the cleanest ways to give money directly to your grandchildren without having that money go through their parents (your children) first. This is also a way to pay the estate or inheritance tax just once. As you navigate this complicated financial terrain, consider enlisting the help of a financial advisor to make sure your financial intentions are met.
What Is a Generation-Skipping Trust?
A generation-skipping trust is just what it sounds like. It’s a legally binding trust that skips over the generation right below the person creating it and goes to the next one. Essentially, it skips your kids and passes directly to their kids, your grandchildren. The money in this trust is never officially owned by the generation it is skipping — it passes directly to the following generation instead.
Blood relation is not necessary for a generation-skipping trust to work. You can designate anyone who is at least 37.5 years younger than you, and who also isn’t your spouse or ex-spouse, as the recipient of funds in a generation-skipping trust. If that’s someone who isn’t actually your grandchild — perhaps a friend or great-nephew or niece — that works just as well for a generation-skipping trust.
How Generation-Skipping Trusts Are Taxed
While the love of your grandchildren is all well and good, the most common reason for using a generation-skipping trust is to avoid having the money be subject to the estate or inheritance taxes twice. The federal estate tax threshold for 2022 is $12.06 million. Some states also have their own estate taxes that generally, but not always, come with lower thresholds than the federal tax. These taxes apply to estates before any money is inherited. Some states also have inheritance taxes, applied after the money has been inherited. There is no federal inheritance tax.
By using a generation-skipping trust, you are essentially avoiding one round of the state inheritance tax. Think about it this way — if you pass your money to your kids, it could be subject to the estate or inheritance tax. Years from now, when your kids die and pass the money on to their children, if your family still has enough money to have to pay the estate tax, the money will be taxed again. By using a generation-skipping trust, the money isn’t taxed when the second generation in this scenario dies.
You can pass along up to $11.40 million — the same as the estate tax exemption — in a generation-skipping trust and only the estate tax applies. In fact, if you’re married, both you and your spouse can give $11.40 million for a total of $22.80 million. Any money over that limit is also subject to the generation-skipping transfer tax, which is a flat 40% tax. That’s a significant tax, so it probably doesn’t make sense to put more than the limit into a generation-skipping trust.
When to Use a Generation-Skipping Trust
If you have an especially large estate — one that is likely to be hit by the federal estate tax, and one where your children will also end up having to pay the estate tax — a generation-skipping trust is likely a good idea for capital preservation. The only thing to note is that the trusts are irrevocable. Once you put the money into them, you cannot remove it. So make sure you are positive you want to use a generation-skipping trust before you actually make the move.
A generation-skipping trust probably isn’t needed for smaller estates. You can certainly use one if you want, but it likely isn’t worth the effort.
How to Create a Generation-Skipping Trust
A generation-skipping trust is a complicated legal entity. Creating the trust requires certain legal documents to be created which stipulate how and when the money is to pass to the next generation. The money is then essentially put into escrow and is owned by the trust and only released by the executor of that trust (typically a financial advisor or lawyer).
Though you can create one yourself with an online provider, working with a financial professional to create one is typically best. This could be your existing financial advisor, but make sure he or she has expertise in trusts and estate planning, and finalize all the legal paperwork with an attorney.
Bottom Line
A generation-skipping trust is a useful tool for those with especially large estates. It allows you to give money directly to younger friends or family members, saving your family some estate tax payments down the line. Up to $12.06 million per person is subject only to the estate tax, while any funds greater than that amount are also subject to an additional 40% tax. A financial advisor specializing in trust and estate planning can help you set up a generation-skipping trust.
Tips For Estate Planning
- Estate planning can be hard. Finding the right financial advisor who fits your needs doesn’t have to be, though. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- When writing a will, don’t forget to include someone to take care of your kids. You want to be prepared, even if you hope it won’t be needed.
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