You have to be concerned about preserving your wealth if you have been financially successful throughout your life. There is a federal estate tax that carries a hefty rate, and it can significantly erode the wealth that you are passing along to your loved ones. In 2014, the maximum rate of this tax is a robust 40 percent, so we are talking about a rather large bite.
This is not the only federal transfer tax. If it was, you could give gifts while you are living to avoid the estate tax. To close this loophole there is a federal gift tax, and it has been unified with the estate tax since 1976.
There is a unified lifetime exclusion that stands at $5.34 million for the rest of 2014. This amount could be raised in 2015 to account for inflation. Because the estate tax is unified with the gift tax, this exclusion applies to the combination of gifts that you give that are taxable along with the value of your estate.
Generation-Skipping Transfer Tax
Back in 1976 when the gift tax and estate tax were unified, the generation-skipping transfer tax was enacted. There were certain difficulties that arose out of the original version of the tax, so it was repealed in 1986, and a new version was enacted.
This version set the rate of the generation-skipping transfer tax equal to the maximum rate of the gift and estate tax, so the rate is a flat 40 percent in 2014.
To a large extent, the tax is self-explanatory. The generation-skipping transfer tax can be applied on asset transfers to family members who are more than one generation younger than you are. This tax can also be applicable on asset transfers to people who are not related to you who are at least 37.5 years younger than you.
The tax is only going to be applicable if the transfers in question would have been subject to the gift tax or the estate tax.
In spite of the existence of the generation-skipping transfer tax, people who are exposed to the estate tax sometimes use generation-skipping trusts.
The beneficiaries of the trust would typically be your grandchildren. It can seem as though your children would be passed over if you implement this strategy, but this is not the case.
The children could benefit from assets that have been conveyed into the trust throughout their lives. They could receive income, and they could utilize property that had been conveyed into the trust.
After the death of the children, the grandchildren would inherit the assets that remain in the trust. The generation-skipping transfer tax would be applicable, but two generations benefited from the assets. There was just one round of taxation over two generations, and this is the advantage that you gain with a generation-skipping trust.