What is a 'Generation-Skipping Trust'

A generation-skipping trust is a type of legally binding trust agreement in which the contributed assets are passed down to the grantor's grandchildren, not the grantor's children. The generation to which the grantor's children belong skips the opportunity to receive the assets to avoid the estate taxes (taxes on an individual's right to transfer property upon his death) that would apply if the assets were transferred to them.

BREAKING DOWN 'Generation-Skipping Trust'

Because a generation-skipping trust effectively transfers assets from the grantor's estate to his grandchildren, the children of the grantor never take title to the assets. This is what allows the grantor to avoid the estate taxes that would apply if the assets were transferred to his children first. The recipient of a generation-skipping transfer doesn't necessarily have to be a family member; the beneficiary can be anybody other than a spouse or ex-spouse, as long as the beneficiary is at least 37.5 years younger than the grantor. Generation-skipping trusts are effective tools of wealth preservation for individuals with significant assets and savings; 2016 estate taxes in the U.S. range from 18 to 40%, depending on the amount of wealth being transferred.

Generation-skipping trusts can still be used to provide some financial benefits to a grantor's children because any income generated by the trust's assets can be made accessible to the grantor's children while still leaving the assets in trust for his grandchildren.

Generation-Skipping Transfer Taxes and Tax Exemptions

Due to the generation-skipping trust's viability as a loophole to avoid federal estate taxes, changes were made to the tax code in 1986 that created a generation-skipping transfer tax. Tax exemptions, as secured by the American Taxpayer Relief Act of 2012, ensure that people transferring modest sums of wealth to younger generations don't have to bear the brunt of the tax burden. The American Taxpayer Relief Act of 2012 established a permanent $5 million tax exemption on generation-skipping transfers, which means that there is only a federal tax on a generation-skipping transfer of wealth if the amount of wealth exceeds $5 million. This amount of $5 million adjusts to account for inflation; the generation-skipping transfer tax exemption increased from $5.43 million in 2015 to $5.45 million in 2016.

Generation-skipping transfer tax rates have risen and fallen over the years, with a recent high of 55% in 2001 and a low of 0% in 2010. Even since the installment of taxes on generation-skipping transfers, generation-skipping trusts still serve as a tool for high net worth individuals (HNWIs) to transfer wealth at a lower tax rate.

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