Preserving Your Money for Future Generations

This strategy can keep your fortune in the family virtually forever.

Who would you like to enjoy your wealth? You, your spouse and your family, or the IRS? And by “family” I mean not only your children and grandchildren, but also future generations.

By forming a dynasty trust, you can legally disinherit the IRS and have your wealth pass estate-tax-free from generation to generation. Such an irrevocable trust can benefit one or more beneficiaries, typically your children and/or grandchildren and their future descendants.

The “magic” of a dynasty trust is that it could potentially last forever. Your children can receive various benefits during their lives, then your wealth will pass from them to your grandchildren and on to future generations. And most importantly, each of these wealth transfers is estate-tax-free.

When you transfer assets to the trust, they can be subject to a gift tax. Under current laws, however, you can gift as much as $5.35 million ($10.68 million if you are married and gifting with your spouse) without that gift being taxed.

Say, for instance, that 25 years after your initial gift, your son dies and his share of the trust is transferred to his children. That transfer is not subject to estate taxes because your son did not actually own the assets. The trust owned the assets before he died and still owns them after his death. Technically, there was no title transfer of the assets, so there is no gift tax or estate tax. The best example I have ever seen that illustrates the dramatic difference in benefits between a dynasty trust and an outright gift to heirs is from an article posted by virtual publisher Planned Giving Design Center in January 2000. (The tax in the table below has been updated to 40 percent, which is the current highest estate tax bracket.)

Assume you gift $1 million to a dynasty trust. The trust benefits your child, grandchild and great-grandchild for their lives and will pass outright to your great-great-grandchild. After distributions are made to the various beneficiaries, the trust grows by a net amount of 6 percent annually. 

  Dynasty
Trust
Outright
Gift

Gift

$1.0 $1.0
Value at death of child $4.5 $4.5
Less 40% estate tax $0 $0
Balance $4.5 $4.5
Value at death of grandchild $19.6 $11.7
Less 40% estate tax $0 $4.7
Balance $19.6 $7.0
Value at death of great-grandchild $83.8 $30.2
Less 40% estate tax $0 $12.1
Great-great-grandchild receives $83.8 $18.1

(Dollar figures are rounded and in millions.)

As you can see, tax-free compounds wealth. And this table illustrates a gift of only $1 million to fund the dynasty trust. Most people gift more.

Other Factors to Consider
• Income taxes. This example addresses estate taxes, but what about income taxes? In general, irrevocable trusts like a dynasty trust pay tax (federal and state) on their income. Any type of asset can be gifted to a dynasty trust, but selected assets—such as municipal bonds, low- or no-dividend growth stocks, and non- or low-income assets likely to appreciate—are your best choice.

A dynasty trust also can be structured as a “grantor trust,” making the trust itself a tax-free entity. Instead, the creator of the trust pays tax on the income, and those payments are gift-tax-free to the beneficiaries and the trust. Once the creator dies, the trust becomes subject to income tax. 

• Location of the trust. Years ago, all 50 states used the so-called “rule against perpetuities” to prohibit dynasty trusts from having a life beyond about 90 years. After that, all assets had to be distributed to the then-beneficiaries and the trust terminated. This rule still holds in most states, but 23 states and the District of Columbia do allow use of dynasty trusts. Even if you don’t live in one of these states, you can create your trust in one of them and then determine how long it should last, whether three generations, five generations or forever. But choose a state that does not have a state income tax.

• Trustees. Because of the long life of the typical dynasty trust, the trustee is usually a bank or trust company. The trust should also allow for removal of the trustee to prevent it from being held captive to high fees or poor performance.

• Use of trust funds. Consider supplementing the income of an existing or yet-unborn heir who engages in socially beneficial work or a low-paying profession. Also, to prevent the beneficiaries from becoming dependent solely on the trust for support, consider using it to provide incentives for such accomplishments as graduating from college, or meeting specific goals or other objectives that represent your personal values. You could also use the trust as a family foundation, providing gifts to charity from it.