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If you're lucky enough to have grandchildren and want to help support them financially, you should know about the generation-skipping transfer tax. This tax could also apply to a substantial gift to anyone else who's at least 37 1/2 years younger than you. Congress created this tax in 1976 to close what otherwise might have been a "loophole" that enabled individuals and couples to minimize, or even completely avoid, estate taxes.
Key Takeaways
- The generation-skipping transfer tax applies to assets given to grandchildren and other younger recipients that bypassed one generation.
- The tax applies to transfers of anything of value, not just cash, and even the establishment of a trust for a grandchild could trigger a tax liability.
- To avoid a capital gains tax liability, consider the timing of the gift and keep in mind the estate tax exemption, which in 2023 is $12.92 million for an individual and $25.84 million for a couple.
What Is a Generation-Skipping Tax?
This tax applies to assets given to grandchildren, great-grandchildren and other younger recipients that bypassed one generation (such as your own children), and therefore also avoided whatever gift or estate tax liability they would otherwise have incurred.
The good news is that, like estate tax in general, most estates aren't large enough to be subject to the generation-skipping transfer tax. Even so, for planning purposes, it's important to know how it works.
First, the generation-skipping tax applies to transfers of anything of value, not just cash. For example, if you bestowed some real estate on a grandchild, that could trigger a tax liability. Also, establishing a trust for a grandchild, which may make sense if the beneficiary is too young to manage an inheritance, does not eliminate possible exposure to a tax liability.
Avoiding a Capital Gains Tax Liability
The timing of your gift (and the possible triggering of a generation-skipping tax liability) is an important consideration. If you make a gift while you're alive, the value of the gift at that time would be used to determine whether it incurs a gift tax liability. However, your grandchild (or younger recipient) would also "inherit" your tax basis of the gift.
That means, for example, if you gave your grandchild $500,000 worth of stock that you only paid $200,000 for when you bought it a decade ago, your grandchild would also be treated as having "paid" the same $200,000 price. So when your grandchild sells that stock, they could face a tax liability on the $300,000 increase in value.
If your grandchild inherited the stock when you died, he or she would have a "stepped-up" tax basis that's equal to the value of the stock when you died. In other words, the grandchild ultimately would only face a capital gains tax liability on any value of the stock exceeding $500,000.
The Estate Tax Exemption
As noted, the generation-skipping transfer tax, which has a rate of 40 percent, is not incurred by most people. That's because it only applies when you have used all of your lifetime estate tax exemption.
Also, a surviving spouse "inherits" the deceased spouse's estate/gift tax exemption. That means, for example, if your spouse died before you started giving large gifts to grandchildren (or anyone else, for that matter), you could give away $22.8 million before any generation-skipping transfer or estate tax liability would incur.
Also, as of 2023, you can give away $17,000 to as many people (grandchildren included) as you want every year without whittling away at your estate tax exemption. Your spouse can, too, if you have one. As a couple, you can jointly give $34,000 a year to anyone you want without having to worry about the generation-skipping transfer tax — or any other kind of gift tax. And you'd still be able to give away the maximum $11.4 million or $22.8 million amount when you die without estate tax consequences.
If you're confident that your estate is more than sufficient to meet your financial needs for the duration of your life, starting to plan a gifting strategy for your grandchildren (or any other younger recipients) might be a good idea. As you get started, keep these tips in mind and stay educated on the most current generation-skipping tax laws so you can come up with a plan that works best for you.
