A generation-skipping trust is exactly what it sounds like - a trust in which a grantor's assets are locked up in a trust to be transferred the grantor's grandchildren, while skipping the grantor's children. This is not intended as a punishment for children or an incentive to have grandchildren. Rather, it is used to escape the dreaded estate taxes which can take a bite out of inheritances. If the grantor's children directly inherit the grantor's assets, they will be taxed the standard 45% estate tax. Later on, when the grantor's children wish to pass their assets on to their children, they will be taxed 45% again. The generation-skipping trust is designed specifically to escape these taxes while protecting your family's assets from generation to generation as they appreciate in value. This does not mean that the grantor's children are left out completely; the grantor can still make income generated by the trust's assets, such as dividends, available to his or her children. Generation skipping trusts are often used by "old money" families which are already affluent, with the intention of preserving wealth from generation to generation while avoiding estate taxes. However, there are ways which upper middle-class families with substantial savings can also use these to preserve wealth.
The children of a grantor can face all sorts of financial calamities - such as divorces, failed businesses, medical bills or financial debt. The generation skipping trust protects the family's wealth from all of these. For example, if a grantor's child divorces, the divorcing spouse cannot lay claim to any of the trust assets, since they were never the child's to begin with. Likewise, if the grantor's child starts a company and ends up drowning in debt, he or she will still have no legal authority to use the trust assets as collateral. Grantors can also put real estate or securities intended for long term appreciation into the trust, to guard them from being prematurely sold off. Grantors can then assign the stock dividends to be paid to their children as primary or supplementary income. The grantor's grandchildren can withdraw from the trust once all of the grantor's children die.
There are, however, limitations on the size of a generation-skipping trust. The current tax-free limit is $2 million per person, which means if you plan to leave less than that in the trust, your grandchildren can withdraw the total amount tax free. However, every dollar over that limit will be taxed at the 45% estate tax rate. Therefore, a trust with a value of $3,000,000 will be subject to $450,000 in taxes upon withdrawal, since it is $1 million over the limit. The $2 million limit includes asset appreciation - for example, if you deposit $1 million in securities into your trust while you are alive, then these assets appreciate to $1.9 million by the time your grandchildren wish to withdraw, then they can withdraw all of the assets tax free. However, if the securities triple in value to $3 million, then your grandchildren will have to pay $450,000 in taxes. Therefore, there is mathematical gravity which will pull these assets back to earth if they appreciate too much. If these securities rise ten-fold in value to $10 million, your grandchildren would end up paying $2.9 million in taxes, erasing a large portion of the gains.
If your parents have already set up a generation-skipping trust and you and your spouse have a fair amount of savings, then you should set one up yourself. This keeps the chain of trusts going and minimizes the tax liability for your family in generations to come.