Maybe you’re not Bill Gates or Donald Trump, but you’ve worked hard to build up a small business empire of your own. Now that you’re closing in on retirement, you’d like to preserve most of your assets for your family without paying an arm and a leg in taxes.
Strategy: Set up a dynasty trust. Unlike a typical trust lasting for a limited term or ending upon a specified event, a dynasty trust can span several generations without triggering adverse tax consequences.
And there’s more. Besides the tax benefits, the trust may be used to protect your wealth under the personal conditions you impose (see box below).
When should you establish a dynasty trust? There’s no time like the present. Your family may benefit from the generous $5 million estate tax exemption currently allowed by law.
How a dynasty trust works
In brief, you transfer assets to a trust—either as a lifetime or a testamentary transfer—and designate a trustee to administer the trust and manage investments.
Don’t name yourself as trustee or you run the risk of undoing the tax benefits. Once you establish the trust, it’s irrevocable. In other words, you must be willing to give up control over the assets.
The income generated by the assets can accumulate within the trust, or you can arrange annual payouts to designated beneficiaries like your children and grandchildren. The trustee may also have discretion to invade the principal for the “health, education, support and maintenance” of the beneficiaries or for other extenuating reasons.
How long does a dynasty trust last? The duration depends on the law in the state where the trust is created. In some cases, it can last for hundreds of years or indefinitely.
Here’s the tax kicker: The transfer to the trust is sheltered from tax by the unified estate and gift tax exemption. For transfers in 2011 and 2012, the exemption is $5 million, the highest it’s ever been. (It’s scheduled to revert to $1 million in 2013 unless Congress acts.)
This exclusion doubles to $10 million for a married couple and portable between spouses. This may enable you to bankroll your family for decades.
Best of all, the assets in the trust won’t be included in your taxable estate when you die. So your wealth can compound over time without any tax erosion. This could leave your heirs with literally millions of dollars—all of it estate tax-free.
Another point: The tax law generally imposes a special “generation-skipping tax” (GST) on transfers that bypass a generation, even when assets are transferred to a trust. But you can utilize a generous exemption from the GST. As with the federal estate tax exemption, the GST exemption is currently $5 million ($10 million for a married couple).
Where will the assets come from? One common method for funding a trust during your lifetime is to use a second-to-die life insurance policy.
When the surviving spouse dies, the policy pays the proceeds to the trust, without any estate tax reduction. Thereafter, the policy proceeds or assets purchased with the proceeds can continue to provide income or grow for the remainder of the trust term.
Tip: This is not a do-it-yourself proposition. Consult with an expert estate planning pro.
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