In addition to federal and state income and capital gain taxes and state inheritance, death and estate taxes that may apply, here are really two separate federal transfer tax structures that may apply when leaving assets to family- the Lifetime Gift & Estate Tax and the Generation Skipping Tax. The Gift & Estate Tax applies to all gifts.
The Generation Skipping Tax is unrelated to the Gift & Estate Tax and applies whenever gifts are made to a generation below a living generation. Excluding calculations for annual gifts, each tax applies an exemption of approximately $5,250,000 adjusted for COLI, the Cost of Living Index. Beyond the exemption amounts, one or both taxes may apply.
Lifetime Estate Tax Exemption
Most are familiar with the Lifetime Tax Exemption, where each individual has a certain amount of federal tax exemption that they can leave to their (spouse or) children; anything over that amount will be taxed, in 2013 at a rate of 40% in excess of $5.25M in exemptions, as adjusted.
If the funds are left to the surviving spouse, either directly or in an A trust, and proper forms are filed to preserve any unused Lifetime Tax Exemption, the first spouse to die’s assets will be added to the surviving spouse’s estate and the surviving spouse’s exemption will be as much as $10,500,000 plus COL increases.
The law says that you can leave $5.25M to your kids, or grand-kids, or whomever you want. But if you leave more than $5.25M to your grandchildren, it’s not going to be taxed in your children’s estate, because you are leaving it to their children. In that case, the federal government is going to apply a “generation-skipping” tax on all amounts in excess of $5,250,000. The tax on this transfer is not credited against the 40% Estate Tax, and applies a second 40% Generation-Skipping Tax on the entire amount in excess of $5,250,000 as adjusted by COLI. This means the total tax could be 80%, exclusive of any income taxes. If the estate involves a very substantial retirement plan, the income taxes will also be due on the principal.
Persons with very large retirement plans or who anticipate inflation should consider these combined taxes. There was a time when $600,000 was a large exemption. Apply the rule of 72 to all planning, and consider life expectancy. By doing so, unnecessary taxes can be minimized and maximum financial benefit can better pass to future generations.