Matthew Johnston is an advanced planning attorney at Northwestern Mutual.
For affluent families looking to leave a legacy of multigenerational wealth, dynasty trusts are one of the most powerful tools in your estate planner’s toolkit. When properly drafted, dynasty trusts help pass on more of the wealth you’ve worked hard to build and preserve by strategically avoiding estate, gift and generation-skipping transfer (GST) taxes. In other words, these trusts are designed to mitigate the substantial family wealth depletion that occurs when assets transition across numerous generations.
In this article, we explore:
- What a dynasty trust is.
- The pros and cons of a dynasty trust.
- Creating a dynasty trust.
- Dynasty trust income tax considerations.
- Funding your dynasty trust.
- Whether a dynasty trust is right for you.
What Is a Dynasty Trust?
A dynasty trust is a type of irrevocable trust designed to pass assets from generation to generation while minimizing estate, gift and GST taxes (collectively known as transfer taxes). Often, high-net-worth families use dynasty trusts to transfer assets to children, grandchildren, great-grandchildren and beyond.
The key difference between dynasty trusts and other types of irrevocable trusts is duration. While other types of trusts terminate at a predetermined point in time (such as when children reach a certain age), dynasty trusts can exist for an exceptionally long time or even forever, providing financial benefits for numerous future generations while avoiding transfer taxes. Because some states have laws against perpetual trusts, it is crucial to work with a knowledgeable estate planning attorney to help you choose which state to establish your dynasty trust in.
Dynasty trusts have many benefits for wealthy families looking to leave a financial legacy, including:
- Protecting your and your beneficiaries’ assets from creditors and divorce.
- Centralizing family wealth management.
- Helping your beneficiaries pay for education, health care, housing, etc.
- Avoiding estate, gift and GST taxes at each generation.
While dynasty trusts have many benefits, it’s also important to be aware of potential drawbacks. For example, dynasty trusts:
- Can be expensive to create and maintain.
- Are irrevocable and cannot be changed after creation, other than limited changes by a trust protector.
Creating a Dynasty Trust
While the laws governing trusts vary from state to state, these are the steps you generally need to take to set up a dynasty trust:
- Meet with your advisory team – First, you should meet with your financial advisor, tax professional, estate planning attorney and any other members of your advisory team to discuss your family’s wealth transfer objectives and how a dynasty trust can help meet those goals.
- Identify beneficiaries – You’ll need to specify whom you want to receive the trust assets. Often, these will be your children, grandchildren and other future descendants.
- Design your trust for now and the future – Because dynasty trusts are irrevocable and generally can’t be changed after they are set up, determining how your trust will operate and distribute assets is critical. The future is unpredictable, so it’s common for dynasty trusts to be written in such a way that they accommodate the unknown. Often, this results in trustees having discretion over how and when assets can be distributed to beneficiaries.
- Identify the trustees and trust protector – A trustee is given the authority and power to administer any assets held by a trust. Importantly, this person assumes fiduciary responsibility for the trust, its assets and current and future beneficiaries. As a fiduciary, a trustee can be held liable for any breach of that duty. Sometimes, in addition to trustees, a trust protector is empowered to make certain limited changes to the trust to add flexibility to an irrevocable trust designed to last for centuries.
- Choose professional asset managers – Due to the value of assets and the complexity and duration of dynasty trusts, dynasty trusts often utilize a professional corporate trustee and a financial advisor to help manage the investment and insurance assets held in the trust.
- Fund the trust – Once your trust is drafted, you’ll need to fund it. Dynasty trusts can be funded either during your lifetime or at death with a variety of assets, including life insurance, business interests, investments, real estate and other assets.
Dynasty Trusts and Income Taxes
When funding your dynasty trust, if you place income-generating assets into it (such as a family business), income tax will need to be paid on the income generated. While trusts are highly effective at avoiding transfer taxes, they typically do not provide income tax savings for high-net-worth families.
Funding Your Dynasty Trust
Leveraging the Estate, Gift and GST Exemptions
To maximize transfer tax efficiency, most trusts are primarily funded using the estate, gift and GST tax exemptions available to all taxpayers. In fact, a dynasty trust is one of the best ways to leverage these exemptions. And, thanks to the Tax Cuts and Jobs Act (TCJA), by funding your dynasty trust before 2026, you have access to the historically high estate and gift tax unified exemption as well as the historically high GST tax exemption, which are both set to $12.92 million per taxpayer in 2023. Because this benefit is available to all taxpayers, that means married couples could gift a combined $25.84 million in 2023.
As a result, married grandparents can make lifetime gifts to trusts of which children, grandchildren and future generations are beneficiaries of up to $25.84 million in 2023 without incurring gift, estate or GST tax. Using a dynasty trust as the vehicle for the transfer leverages the gift by enabling the assets in the trust to be free from estate or GST tax in the future when the grandparents and other future generations die. If you have assets above and beyond what you can transfer using your available estate, gift and GST tax exemptions, you can also utilize estate planning strategies to sell assets to your dynasty trust. Because dynasty trusts must be carefully drafted to achieve the desired estate and GST tax results, it is important to partner with a knowledgeable estate planning attorney.
Life Insurance, Investments and Other Assets
Your dynasty trust should be funded and managed with a multigenerational time horizon in mind. Therefore, you’ll want to give careful consideration to the initial funding and later management of assets in your dynasty trust. It’s a good idea to engage an experienced financial advisor to help you determine how the dynasty trust should be funded and how assets in the dynasty trust should be managed by the trustee. Often, dynasty trusts are funded with or acquire a managed portfolio of investments, life insurance, real estate, business interests and other assets.
Thoughtful planning is also needed around income tax considerations, cash flow, liquidity and risk tolerance. If your dynasty trust is designed properly, all assets in your trust should avoid future transfer taxes. However, most dynasty trust assets are generally subject to high income tax rates. An experienced financial advisor would be well positioned to help your trustee build a diversified, income tax-managed investment portfolio.
Life insurance is often a key component of multigenerational dynasty trust planning due to the trust’s extended time horizon and the income tax efficiency of life insurance. The dynasty trust might even own life insurance on you, your spouse and multiple generations of beneficiaries. Permanent life insurance can grow tax-deferred and provide the trust liquidity in the form of accumulated value withdrawals, loans or tax-free death benefits.
Upon the death of an insured person, the permanent life insurance policy’s death benefit may stay in the dynasty trust and be reinvested for the benefit of the future generations. Or, as with an Irrevocable Life Insurance Trust (ILIT), the death benefit can be used to buy assets from an estate, giving an estate sufficient cash to pay estate taxes or make charitable bequests.
Is a Dynasty Trust Right for You?
If you have substantial wealth and are looking to leave a financial legacy that transcends generations, there is a good chance a dynasty trust could be an integral component of your legacy plan. If you are unsure about where to begin or want to learn more about legacy planning, connect with your financial advisor, whose knowledge of financial products and connections to other professionals, like estate planning attorneys and tax professionals, makes him or her a great starting point for your legacy plan.
Tax rates as of 2023, subject to change.
This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
As an attorney in Sophisticated Planning Strategies, I work with Northwestern Mutual financial advisors as they help clients achieve financial security.