Many wealthy individuals and couples struggle to determine how much inheritance to leave to their children, grandchildren, and future generations. Many important questions arise that should be discussed with a CPA, estate planning attorney, or wealth advisor:
- Is there such a thing as leaving too much wealth and money to my children?
- How do I manage my children’s inheritance so it provides them opportunity but also encourages the value of hard work and self-sufficiency?
- How can I protect my children’s inheritance from creditors and themselves?
- Is there a way to support many generations of my heirs after I’m gone?
There are many planning strategies available to help future generations manage both the tax and administrative burden of inheriting and managing wealth. One popular planning tool used by many wealthy families is popularly known as a dynasty trust.
What Is a Dynasty Trust?
A dynasty trust is a type of irrevocable trust that is beneficial for families looking to transfer wealth from generation to generation in a tax-efficient manner. When a dynasty trust is properly designed, it can last for many generations. Once the trust is funded, the “grantor” (the creator of the trust) will no longer have any control over the assets transferred to the trust and is not permitted to amend the terms of the trust. Future beneficiaries of the trust also are not permitted to amend the trust and do not retain enough control to have the assets of the trust included in their estates when they die.
How It Works
For 2022, the lifetime exemption for gift, estate, and generation-skipping transfer (GST) tax is $12.06 million per individual. In other words, an individual can gratuitously transfer up to $12.06 million during their lifetime or at death without incurring any gift, estate, or GST tax. Further, if done correctly, individuals can transfer more than the lifetime exemption amount through annual exclusion gifts of up to $16,000 per individual for 2022 as well as through the direct payment of medical expenses and tuition, but that is beyond the scope of this article.
When the grantor creates a dynasty trust, it is advisable to fund the trust with assets that have high potential for appreciation in the future. This allows these assets to grow outside of the grantor’s estate. The assets are valued at the time the grantor gifts the assets to the trust. Once gifts to the trust are completed, the assets are permanently removed from both the grantor’s estate and the future beneficiary’s estates, meaning no additional gift, estate, or GST tax will be assessed in the future.
The terms of the trust are determined by the grantor at the onset and are carried out by the trustee, who acts as a fiduciary to oversee trust assets and the operation of the trust. The trustee generally has the discretion to distribute money from the trust to support beneficiaries subject to a standard outlined in the trust document. Many of the trust terms can be customized to reflect the grantor’s wishes, say to permit distributions to purchase a house or for a wedding or to withhold distributions under specific circumstances.
Oftentimes, the immediate beneficiaries of a dynasty trust are the grantor’s children. After the death of the last child, the grantor’s grandchildren or great-grandchildren generally become the beneficiaries. A common best practice (that comes with an added cost) is to name a corporate trustee, such as bank or other financial institution, to serve as trustee due to the complexity and perpetuity of a dynasty trust.
Another important consideration when considering a dynasty trust is state law. At one point, most states had laws that prevented trusts from carrying on in perpetuity, meaning the provisions of the trust could not extend beyond the lives of the people living at the time the trust was established. In recent years, many states have removed such restrictions to encourage the use of such trusts. Trusts are governed by state law, so it is important to understand how the trust will be treated in your state. If your state has a rule against perpetuities, there may be a need to establish a dynasty trust in a state other than your state of residence.
Pros & Cons of a Dynasty Trust
As with many wealth and estate planning strategies, there is no one-size-fits-all solution; determining if a dynasty trust is for you depends on a careful analysis of your personal situation. Here are a few considerations:
- Reduces asset transfer tax burden – Gift, estate, and GST tax is only assessed once at the time the grantor funds the trust.
- Protects assets from creditors – Because the assets are owned by the trust and not by the beneficiaries, the assets are not included in the taxable estate of the beneficiaries. This means that creditors and divorce courts cannot go after the assets held by the trust.
- Assets held in trust avoid probate – Assets held in trust do not go through the court-supervised process of probate at the death of the grantor.
- Flexibility in drafting the trust document – Trust language can generally be as vague or as detailed as the grantor wishes. This allows the grantor to limit the beneficiaries’ access to the assets to the extent desired. It also is possible to provide beneficiaries with a limited power of appointment to leave assets to specific heirs or charities of their choosing at their deaths.
- Preserve family wealth for many generations – The grantor can draft the trust agreement in a manner that increases the odds that many generations can benefit from the trust in perpetuity.
- Irrevocable – The grantor cannot change the trust once it is created.
- Limited flexibility for future generations – Descendants generally cannot change the terms of the trust, even if circumstances change in the future.
- Trust income is subject to tax – To reduce the income tax burden at the trust level, individuals often transfer assets to dynasty trusts that don’t produce taxable income, such as nondividend-paying stocks, tax-free municipal bonds, and life insurance policies.
- Added tax compliance costs – Annual tax returns must generally be filed for the trust.
Is a Dynasty Trust Right for You?
Dynasty trusts are best suited for wealthy individuals with significant assets they wish to leave to future generations in a tax-efficient manner. Due to their complexity, it is important to consult with your trusted tax and financial planning professional to see if a dynasty trust is right for your situation. For more information, please contact your FORVIS Private Client professional or submit the Contact Us form below.