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Tax-Smart Intergenerational Planning Strategies

Insights & Ideas Team •  April 27, 2016 | Your Finances

For many high-net-worth families, intergenerational wealth transfer is an important consideration, especially in situations in which children are already financially secure. Taking advantage of proven intergenerational wealth transfer strategies allows you to provide for your grandchildren and future generations while minimizing the impact of taxes.

However, federal tax law in the form of the generation-skipping transfer tax, otherwise known as the GST tax, makes high-net-worth giving complex. Because gifts or legacies that “skip” a generation avoid the payment of estate tax at the child’s level, the GST tax is designed to collect that tax. Just as with the estate tax, a base amount—$5.45 million in 2016—is excluded from the GST tax. The gift, estate and GST tax exemptions are unified, so the same amount includes all three types of exemptions. Above that amount, the GST tax kicks in unless steps are taken to avoid it.

“Generation-skipping transfer taxes are the biggest threats to intergenerational transfer strategies that aim to bypass children,” says Phil Roemaat, JD, CPA, senior attorney – Advanced Planning, Northwestern Mutual. “These taxes impose an additional inheritance tax on transfers of wealth to individuals other than children either by gift during your lifetime or through inheritance after death.”

Through proactive planning, there are several strategies that maximize the potential to gift or leave inheritances to future generations by avoiding the GST tax, Roemaat says, depending on your estate tax situation. These include gifting to grandchildren by taking advantage of the annual gift exclusion and establishing dynasty trusts.

Take Advantage of Yearly Gifting

If you are close to or just above the estate tax limit, you may want to gift money out of your estate through the annual gift exclusion. While you can make cash gifts up to the yearly limit, one of the best ways to pass money to your grandchildren is with Section 529 college savings accounts. This type of college savings account permits grandparents to own the account and exercise complete control over contributions, investment decisions and distributions. The grandparents can even change the beneficiary should the child decide not to pursue higher education.

“Gifting through Section 529 college savings plans represents a unique opportunity to exclude a significant amount of cash from an estate while providing flexibility and concrete tax advantages for your grandchildren and their parents,” Roemaat says.

There are several ways to gift funds through Section 529 plans—on a yearly basis or through a five-year gift. Here are the specifics:

  • Yearly gift: Individuals can gift up to the annual gift exclusion—currently $14,000—for each grandchild, while a couple can gift a total of $28,000 to each grandchild.
  • Five-year gift: Through a five-year gift, grandparents can gift five years of annual exclusions at once. Married grandparents can give $140,000 to each grandchild; and single grandparents, $70,000 to each grandchild. However, if the giver passes away during that five-year period, parts of the gift would come back into the donor’s estate.

Your Estate Plan: Is a Trust Right for You?This method of gifting is highly beneficial to you, the parent and the grandchild. For you, a gift to a Section 529 plan is treated as a direct, present interest gift directly to the designated beneficiary, avoiding allocation of GST tax exemption. If you have multiple grandchildren, you can gift a significant amount through this strategy each year or employ the five-year gifting strategy. For example, a couple with five grandchildren employing the five-year gifting strategy could remove $700,000 from their estate.

“For parents and grandchildren, funds in Section 529 Savings accounts grow free from income taxes, as long as they are used for expenses related to attending college, otherwise known as qualified expenses,” Roemaat notes. Qualified expenses include college tuition, room, board, fees, books, supplies and equipment.

Dynasty Trusts

If you have a large estate and will exceed estate tax limits by a great deal, you may want to set up a dynasty trust to shelter money from taxes and provide for future generations. Under current tax law, establishing a dynasty trust enables you to avoid estate, gift and generation-skipping taxes for future generations.

The number of future generations that can be skipped depends on the laws of the state where the trust is established. By placing assets in this kind of trust, you can create financial security for multiple generations rather than just one or two generations—your children and grandchildren.

“A dynasty trust, a type of irrevocable trust, provides a solid option to keep an ample supply of funds on hand for your family for as long as possible while avoiding transfer taxes,” Roemaat notes.

These trusts can be funded with cash (up to the current estate tax limit, which this year is $5.45 million for an individual or $10.9 million for a couple), life insurance, business interests or other assets. Employing life insurance provides a number of benefits:

  • Death benefits flow into the trust income tax free.
  • Life insurance cash values grow tax free.
  • Trust assets can be used to buy policies on children, grandchildren, great-grandchildren and so on.

“When setting up the trust, you have control over the mechanisms under which benefits are paid,” Roemaat says. “Examples of this include school tuition payments, helping to pay for weddings and buying first homes.”

Many states have abolished rules against perpetuities. Some states have legislated a long time frame that trusts can exist, like Nevada (365 years), or some have no time limit, like South Dakota. Some states also have little or no state income taxes on trusts domiciled in that state. Additionally, some states also have laws that allow trusts to avoid paying alimony or child support in the event of divorces in future generations, providing protection to the estate and its assets.

Consult With Your Financial Professional

If you’re considering intergenerational wealth transfer strategies, such as Section 529 gifting or establishing a dynasty trust, consult with your financial professional. He or she can help you determine which vehicles are the best approaches for you to achieve your legacy planning goals in the context of your overall financial and investment plan.

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