For most, 'Generation Skipping' will likely not be an issue with your estate. However, you may hear the term. Curious as to what it means?
To understand Generation Skipping, let's quickly review Estate Tax. Remember that the Estate Tax is a tax levied on the estate of an individual before it can pass to his or her heirs. A key element of the Estate Tax is the exemption amount. This is an amount of the estate that is not subject to estate tax.
So, for example, if we have an estate with a value of $1,000,000, and the exemption amount is $400,000 - then the first $400,000 of the estate would not be subject to estate tax. Only the $600,000 of the estate that exceeds the exemption amount would be taxed.
These days (as of 2023), the exemption amount is in excess of $11 million. So unless you have an estate with a value in that range, estate tax probably isn't a concern for you. However, there was a time, not so long ago, that the exemption amount was much lower. Because of this families were constantly coming up with different ways to try to avoid the estate tax. (Remember, tax avoidance is perfectly fine - tax evasion is illegal.)
One plan to minimize estate tax was the idea of generation skipping. The concept went like this.
Let's Follow the Hypothetical Transfer of $3,000,000 Through the Generations
In our hypothetical we will follow Grandma's $3,000,000 estate as it transfers first to "Mom" and then to "Daughter." Make note of the estate tax consequences at each transfer.
Grandma
Leaves $3,000,000 to Mom
Exclusion Amount is $600,000, this amount is not subject to estate tax.
The remaining $2,400,000 is subject to an estate tax of $840,000 (35%)
Mom
Receives $2,160,000 from Mom (3 million less the estate tax)
Exclusion Amount is $600,000, this amount is not subject to estate tax.
The remaining $1,560,000 is subject to an estate tax of $546,000 (35%)
Daughter
Receives $1,614,000 from Mom ($2,160,000 less the estate tax)
By the time Grandma’s $3 million reaches Daughter, a total of $1,386,000 in estate tax. (That’s over 46% of the original 3 million!)
Can We Save on Our Tax Bill by Skipping a Generation?
As you can see, each time there is a transfer of the estate, the Estate Tax imposes a hefty tax bill. What would happen if, for example, Grandma just skipped the transfer to Mom and left it directly to Daughter?
If we leave the estate directly to Daughter and 'skip' Mom, then we can theoretically avoid at least one estate tax event and save hundreds of thousands of dollars. So Grandma figures that Mom is doing ok financially, and she can save the $546,000 tax bill associated with the transfer from Mom to Daughter if she gives the money directly to Daughter. So Grandma decides to “skip a generation” to save on taxes.
Can she do this?
The answer is yes. However, the IRS caught onto this and said – Ok. You can skip a generation and avoid the estate tax. But we are going to create a new tax and call it the “Generation Skipping Transfer Tax.”
However, these days, because of the $11 million+ exemption amount, there really isn't a need to engage in this kind of maneuvering to avoid estate tax. In our hypothetical example above, Grandma can leave the entire $3 million estate to whomever she likes and still be well within the current exemption amount and thereby not have to worry about Estate Tax.