Generation-skipping transfer tax tips

Key takeaways

  • Individuals seeking to transfer wealth to grandchildren or other "skip" persons should be aware of the generation-skipping transfer tax, which can make it very expensive to move assets to younger generations.
  • When transferring assets to heirs beyond the next generation, both the generation-skipping transfer tax (GSTT) and gift/estate taxes may apply.
  • Similar to the gift and estate tax exclusion, there is also a generation-skipping transfer tax (GSTT) exemption; with proper planning, it may be possible to maximize the amount transferred by taking advantage of both types of exemptions.

Many people are aware of gift and estate taxes: the taxes that the IRS assesses on the transfer of assets to heirs made either during one's lifetime or at death. But many people are unaware of an additional tax that could apply to transfers made to heirs more than 1 generation below them (e.g., from a grandparent to a grandchild), known as the generation-skipping transfer tax (GSTT). The GSTT is not only unfamiliar to many, but it is also one of the more confusing taxes to understand.

This article will provide a basic overview of the GSTT and discuss how proper planning and use of the GSTT exemption amount may provide a valuable tool for families to shelter their wealth from gift and estate taxation over multiple generations. This article focuses on federal gift and estate tax rules; however, please note that each state may have additional taxes that may affect transfers made during lifetime and at death.

How the GSTT came to be

Transfer taxes were initially introduced in the US early in the 20th century, with the first version of the estate tax implemented in 1916 and the first version of the gift tax implemented in 1924. The GSTT was introduced in 1976, and was implemented to prevent what the IRS perceived as wealthy families avoiding estate taxes at the death of each generation. Prior to this tax, it was possible to pass an unlimited amount of assets to a trust for the benefit of multiple generations, thus permanently avoiding estate taxes as each generation passed away.

Although current gift and estate tax laws provide US taxpayers with higher gift tax, estate tax, and GSTT exemptions than in the 40 years prior—and thus a greater opportunity to transfer wealth and preserve assets for generations to come—it can still be very expensive to move assets to heirs beyond the next generation.

The federal transfer tax system

In general, the IRS assesses a gift or estate tax1 on transfers of assets during one's lifetime or at death to anyone other than a US citizen spouse or a qualified charity, with a few exceptions:

  • The IRS allows individuals to give up to $17,0002 per year to an unlimited number of individuals with no federal gift or estate tax consequences. A spouse can also give the same amount, doubling the amount a couple can gift to any one recipient. For example, a husband and wife with 2 children could give away a total of $68,000 a year to their children ($34,000 to each child) without any tax repercussions. This is referred to as the annual gift tax exclusion.
  • Qualified payments made directly to an educational institution to pay tuition or to a medical provider for medical expenses are disregarded for gift tax purposes. There is no limit on the dollar amount of these qualified payments.
  • Up to $12.92 million (or $25.84 million for a married couple)3 can be transferred to heirs during a lifetime or at death. This is known as the federal lifetime gift and estate tax applicable exclusion. If some or all of the lifetime gift tax exclusion is used to shield gifts from taxation during one’s lifetime, then that part of the exclusion won't be available to shield assets from the estate tax at death.

Above and beyond these 3 exceptions, any transfers during one's lifetime or at death over the federal estate and lifetime gift tax exclusion amounts will be taxed at 40%.4

Demystifying the GSTT

The IRS assesses an additional tax (the GSTT)5 on transfers to individuals (or to a trust for their benefit) that are more than one generation below the transferor (also known as "skip" persons). This would include transfers from a grandparent to a grandchild or to other individuals who are more than 37½ years younger than the transferor (e.g., from a great uncle to a grandniece or from a 70-year-old to a non-related 30-year-old). This tax is equal to the highest federal gift and estate tax rate at the time of the transfer (40% in 2023), and is in addition to any federal gift or estate tax that may be owed.

Similar to the gift and estate tax exclusion discussed above, every US resident also has a GSTT exemption of $12.92 million (or $25.84 million for a married couple).6 In other words, a married couple could transfer up to $25.84 million to a skip person without having to pay GSTT. However, it is important to understand that this is not a standalone exemption. Transfers to a skip person may be subject to both the gift/estate tax and GSTT.7

Let's look at a few scenarios, assuming that a single individual who has not used any of their lifetime gift or GSTT exemption, transfers assets to their child and grandchild.

Gift to child Gift to grandchild Lifetime exclusion used GSTT exemption used Gift taxes owed GSTT taxes owed
$12.92 million $0 $12.92 million $0 $0 $0
$0 $12.92 million $12.92 million $12.92 million $0 $0
$12.92 million $12.92 million $12.92 million $12.92 million $5,168,000* $0
$12.92 million $15 million $12.92 million $12.92 million $6,332,800† $832,000‡
*$25.84 million total gift, minus the $12.92 million lifetime gift tax exclusion, multiplied by a 40% tax rate. †$27.92 million total gift, minus the $12.92 million lifetime gift tax exclusion, plus $832,000 of GSTT owed, multiplied by 40%. ‡$15 million gift to grandchild minus the $12.92 million GSTT exemption, multiplied by 40%.

The example in the bottom row of the table above illustrates how expensive it can be to transfer assets to skip generations once the lifetime exemptions have been used. Total combined gift tax and GSTT of $7,164,800 would be paid for the $15 million gift to the grandchild.

The GSTT annual exclusion Similar in concept to the annual gift tax exclusion ($17,000 in 2023), there is also an annual GSTT exclusion. Thus, if a grandparent wanted to make a $17,000 gift directly to a grandchild (e.g., by depositing funds to a bank account in that grandchild’s name), no gift tax or GSTT would be due (as long as the gift is less than the annual exclusion limit for the year in which the gift is made).8

When does the GSTT apply?

The GSTT is imposed on 3 types of taxable events:

1. Direct skips Property is transferred from one individual to a skip person, either outright or in trust. Direct skips are taxed only once, regardless of how many generations are skipped, and there is no distinction among skip persons regardless of how many levels the beneficiary’s generation is below the transferor's generation. For direct skips, the transferor (or their estate) pays the tax (or utilizes the GSTT exemption) at the time the transfer takes place, based on the value of the property received by the transferee.

Direct skip example

A grandfather gifts $1 million to his grandson or to an irrevocable trust for his sole benefit.

2. Taxable terminations An interest in property held in trust terminates (e.g., due to the death of a beneficiary or the expiration of the trust term), there are no other non-skip beneficiaries, and the termination is not subject to estate or gift tax (e.g., if the trust assets are not included in the deceased, non-skip beneficiary’s estate). This doesn't necessarily mean that the trust terminates. The trust could continue but only have skip beneficiaries remaining. The trustee is responsible for paying the GSTT when the taxable termination occurs.

Taxable termination example

Assets owned by a trust set up for Sally by her mother are distributed to Sally's children upon her death. Due to the provisions of the trust, the trust assets were not included in Sally's taxable estate. This would be a taxable termination assuming Sally's mother did not apply her GSTT exemption to the assets she transferred to the trust (as discussed below). This would also be considered a taxable termination if, upon Sally’s death, the assets remained in trust for her children since there are no longer any non-skip beneficiaries (e.g., no one in Sally's generation is a beneficiary).

3. Taxable distributions An irrevocable trust has been created and a distribution of income or principal is made by the trust to a skip person (but the distribution is not defined as a direct skip or a taxable termination). The GSTT is paid by the recipient when the distribution occurs.

Taxable distribution example

A trust that was set up for Sally and her children by Sally's mother makes a distribution to Sally's children during Sally's lifetime. This would be a taxable distribution assuming Sally's mother did not apply her GSTT exemption to the assets she transferred to the trust (as discussed below).

Allocating the GSTT exemption

In order to avoid the GSTT on the initial transfer, an individual must use (allocate) some or all of one’s GSTT exemption. The GSTT exemption may be used for both outright transfers as well as transfers in trust. The allocation of the GSTT exemption is generally reported on a gift or estate tax return (IRS Form 709 or IRS Form 706), though this is not required by law.9

It is important to note that when the GSTT exemption is allocated to a transfer in trust, any growth on the assets to which the allocation was made is subsequently sheltered from any GSTT in the future.

Allocating the GSTT exemption example

Paul established an irrevocable trust in 2023 for the benefit of his grandchildren and future generations, funded the trust with $10 million, and allocated his GSTT exemption to this transfer. If that trust subsequently grows to $20 million, no distributions to the trust beneficiaries would be subject to any additional GSTT. Thus, Paul only used $10 million of GSTT exemption to shelter what turned out to be $20 million of assets.

Potential planning strategies to transfer wealth over multiple generations

Although outright gifts may be the simplest option (e.g., a $17,000 gift from a grandparent to a grandchild), there may be reasons to explore other possibilities. For instance, grandparents may be concerned that a grandchild might not use the money wisely or grandparents may want the money to be used for a specific purpose, such as to pay for college.

Contributions to 529 plans for the benefit of grandchildren (or other skip individuals)

In this case, a common strategy is to make gifts to 529-qualified tuition programs known as 529 plans. Gifts to 529 plans are considered completed gifts, even if the transferor has the right to change the beneficiary at their discretion. A grandparent contributing to a 529 plan for a grandchild's education can accelerate up to 5 years of annual gift exclusions in 1 year (In 2023, $85,000 for an individual, or $170,000 for a married couple). No further gifts can be made by the grandparent to the grandchild or to the 529 plan for that grandchild for the next 5 years without gift tax implications, and if the grandparent dies during this period, a portion of the gift is brought back into the grandparent's estate for estate tax calculation purposes.

Dynasty trusts: multigenerational strategies that don’t exclude the next generation

Another dynastic wealth transfer strategy is to create an irrevocable trust that incorporates both asset protection provisions and generation skipping transfer tax strategies.  For example, a grandparent could create a trust for the benefit of multiple generations that would remove the assets (and appreciation) from the grandparent's estate for transfer tax purposes and help protect the assets from creditor claims against the beneficiaries. These trusts are sometimes known as "dynasty trusts" and can be designed to last indefinitely. However, note that some states limit the number of years a trust may be in existence (known as the "rule against perpetuities").

Dynasty trusts are typically designed to provide for a wholly exempt trust by the allocation of the transferor's (or grantor's) GSTT exemption to all transfers made to the trust. Once a dynasty trust is exempt from GSTT, distributions and terminations will not be taxable events for GSTT purposes regardless of the level of asset growth in the trust.

1. Mom and Dad make an initial gift of $22 million to their child. Mom and Dad's available lifetime gift tax exclusions and GSTT exemptions (applicable only to the dynasty trust scenario) are applied to that gift.

G1 = Mom and Dad's child
G2 = Mom and Dad's grandchild
G3 = Mom and Dad's great-grandchild

2. In the first scenario, the gift is made outright to G1. In the second scenario, the gift is made to an irrevocable dynasty trust that provides for the assets to remain in trust for the benefit of G1, as well as G2 and G3.

3. An after-tax growth rate of 4% is distributed to the beneficiaries each year, resulting in a net growth of 0%.

4. A flat federal estate tax rate of 40% applies.

5. Each generation uses its lifetime estate tax exclusion amount for other assets and, thus, any assets that are part of that generation's taxable estates are fully subject to estate taxes at death.

  Gift to grandchild Gift to dynasty trust
  $22,000,000 $22,000,000
Estate taxes at G1's death ($8,800,000) N/A
Assets remaining for G2 $13,200,000 $22,000,000
Estate taxes at G2’s death ($5,280,000) N/A
Assets remaining for G3 $7,920,000 $22,000,000

In this example, an outright gift to G1 results in a loss of $14.08 million to estate taxes over 3 generations, which are avoided when gifting to a dynasty trust instead. Thus, the annual distributions made to G3 in the dynasty trust scenario (at the 4% rate mentioned above) would be $880,000 (4% of $22 million), versus just $316,800 (4% of $7,920,000) in the outright gift scenario.

A dynasty trust can be combined with other wealth transfer strategies—such as grantor-trust tax treatment, life insurance, family business entities, and loans or sales to the trusts, to name a few—to provide further leverage to a wealth transfer plan. For example, these trusts may also be established as part of an estate plan that includes an irrevocable trust, established and funded at death, generally with amounts up to the decedent's remaining GSTT exemption. Consult your tax advisor regarding what may make sense in your situation.

Final thoughts

Dealing with the GSTT can be complex and confusing. With proper planning, the GSTT exemption provides opportunities to reduce or potentially eliminate the transfer taxes associated with gifting or passing money to grandchildren or other skip individuals, ultimately allowing more to pass to younger generations. Your Fidelity team can help you navigate this complexity, and your attorney and tax advisor can help you effectively plan for GSTT. Contact your Fidelity representative to discuss how GSTT strategies may relate to your personal wealth plan.

The temporary nature of current law The provisions relating to the GSTT exemption in the current tax law are set to sunset at the end of 2025. This means that as of January 1, 2026, the GSTT exemption will revert back to the amount that was allowed under the law effective in 2017 (an inflation-adjusted $5 million, or about half of what is currently allowed). Therefore, if you are considering taking advantage of the higher current exemption amounts, the time to do so is limited, unless Congress acts to change the law once again.

1. Transfers of assets during lifetime or at death may also be subject to state estate, inheritance, and/or gift taxes depending on state of residence or the location of real property. 2. As of 2023. Subject to an inflation adjustment. 3. See endnote 2. 4. As of 2023. 5. Trusts established and funded prior to 1985, which have not been modified, and to which no additional transfers have been made, are exempt from GSTT. 6. As of 2023. 7. In addition, the GSTT paid by the transferor is treated as a taxable gift. 8. Note that transfers to irrevocable trusts are subject to additional rules in order to qualify the transfers for either the annual exclusion or the GSTT annual exclusion. Thus, trusts that are being created for the benefit of a skip person should be carefully drafted to ensure that the GSTT annual exclusion would apply. Also note that the rules differ for the 2 annual exclusions (gift and GSTT). In particular, what may qualify for the annual gift tax exclusion may not qualify for the annual GSTT exclusion. 9. Prior to 2001, in order for GSTT to be allocated to a transfer, there was a requirement to file a gift or estate tax return. In 2001, the laws were changed to provide for automatic allocation of the GSTT exclusion to certain trusts that could have a generation-skipping transfer regardless of whether or not a gift or estate tax return was filed making the election. If the transferor does not want an automatic allocation to be made, the transferor may make an election on a gift or estate tax return reporting the transfer and opting out of the automatic allocation of the GSTT exclusion. Because of the complications surrounding whether a trust is considered subject to the automatic allocation rules, some tax advisors will proactively make an election on a gift or estate tax return to permanently opt in or out of the automatic allocation rules for that specific trust.

Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.

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