The estate tax is something that leaves a lot of people scratching their heads. To break it down very simply, let’s say that you placed a certain percentage of your after-tax income into a savings account from the time you were 16 until the day you retired.
Income taxes had been deducted from the total amount of your pay before you made any of these savings deposits. As long as you live, there are no taxes to pay on this money in the bank, and rightly so; this is money you have managed to hold on to after being taxed. But when you die, the government feels as though they have the right to take 35% of this money as it is passed on to your children.
Let’s say that your children never needed to touch this money, which would be 65% of what you actually left to them. When they pass on and leave it to their children, your grandchildren, it will be taxed yet again! So by the time the money is passed on to the second generation the IRS has taken more than half of it, and you can carry that out down the line until the total finally winds up being less than the exclusion.
Generation skipping trusts are a reaction to this generational asset erosion. You fund the trust and name your grandchildren as the beneficiaries rather than your children. Your children can benefit from the assets in the trust, perhaps receiving the income that it derives, but the trust assets do not belong to them.
When your children pass away the second generation inherits the principal and the estate tax is paid just once instead of twice. An additional benefit that is provided by the creation of a generation skipping trust is that of asset protection. Your children can benefit from the trust, but a former spouse or claimant seeking redress cannot pursue the trust assets.