You're probably aware of gift and estate taxes that the IRS assesses on the transfer of assets to heirs made either during one's lifetime or at death. But you may not be familiar with 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).
What is the generation-skipping transfer tax?
The generation-skipping transfer tax is a Federal tax on transfers of assets or property to individuals (or to a trust for their benefit) that are more than one generation below the transferor. This would include transfers from a grandparent to a grandchild or to other individuals who are more than 37½ years younger than the transferor (the "skip" generation). This tax is equal to the highest federal gift and estate tax rate at the time of the transfer (40% in 2024) and is in addition to any other federal gift or estate tax that may be owed.
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.
What are annual gift tax exclusions?
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 $18,000 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 $72,000 a year to their children ($36,000 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 $13.61 million (or $27.22 million for a married couple) 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%.
The exclusions for transfers to the skip generation are similar. There is an annual generation-skipping transfer tax exclusion. Thus, if a grandparent wanted to make an $18,000 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).2 Every US resident also has a lifetime GSTT exemption of $13.61 million (or $27.22 million for a married couple). In other words, a married couple could transfer up to $27.22 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 and estate tax and GSTT.3
Beyond those exclusions, transfers to the skip generation will also be taxed at 40%.
Finally, keep in mind that the GSTT only applies to Federal taxes; each state may have additional taxes that may affect transfers made during lifetime and at death.
Common GSTT scenarios
Let's look at a few scenarios, assuming that a single individual who has not used any of their lifetime gift or generation-skipping transfer tax exemption, transfers assets to their child and grandchild.
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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 $6,778,400 would be paid for the $15 million gift to the grandchild.
What triggers the generation-skipping transfer tax?
The generation-skipping transfer tax is imposed on 3 types of taxable events:
- Direct skips: When assets are transferred from one individual to a skip person, either outright or in trust. 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 assets received by the transferee.
- 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). For 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. If Sally's mother did not apply her GSTT exemption to the assets she transferred to the trust, this would be a taxable distribution. The GSTT is paid by the recipient when the distribution occurs.
- 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 trust assets are not included in the deceased, non-skip beneficiary's estate. The trustee is responsible for paying the GSTT when the taxable termination occurs.
Allocating the generation-skipping transfer tax exemption
In order to avoid the generation-skipping transfer tax 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.4
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. For example, Paul established an irrevocable trust in 2024 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.
Ways to reduce the generation-skipping transfer tax
Although outright gifts may be the simplest option (e.g., a $18,000 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: A common strategy is to make gifts to 529-qualified tuition programs for the benefit of grandchildren (or other skip individuals). 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 2024, $90,000 for an individual, or $180,000 for a married couple).
Dynasty trusts: Another dynastic wealth transfer strategy is to create an irrevocable trust that incorporates both asset protection provisions and generation-skipping transfer tax strategies. 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.
A dynasty trust can also be combined with other wealth transfer strategies to provide further leverage to a wealth transfer plan. Consult your tax advisor regarding what may make sense in your situation.
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.
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 discuss how GSTT strategies may relate to your personal wealth plan.