Feathering the Nest for Your Descendants: The Dynasty Trust

You know about investment and hard work. You've worked your whole life, reinvested the fruits of your labor time and again, and have finally built a comfortable nest egg that will see you through your golden years and beyond. So what's the next big investment?

How about your family? Yes, with the right estate planning tools, you can provide a head start in life to your children, your grandchildren, and even later generations in your line of descendants. Not only may you pass on your wealth, if you do it through a dynasty trust, you can likely avoid most of the onerous tax burdens that all too often accompany the transfer of large estates.

No Federal Estate Taxes After First Generation

In the current tax system, estate and gift taxes are levied when assets change hands from one generation to the next. A dynasty trust, however, is a legal entity that allows substantial assets to pass to future generations with little or no estate taxes.

So how does a dynasty trust work? Like any trust, a dynasty trust has a trustee that controls it. The trustee can use the income or principle from the trust for the benefit of the beneficiaries (usually your descendants), and you can determine just how broad or narrow the trustee's discretion will be when drafting the trust.

When you create a dynasty trust, there are no initial tax savings - that comes later. Still, many of those setting up dynasty trusts use their estate tax credit, which exempts assets valued up to a certain amount from federal estate taxes (the current estate tax exemption is $5.12 million for individuals, although the limit will drop to $1 million in 2013 if Congress does not act).

The tax saving advantage of a dynasty trust comes in later generations. The assets in the trust, even as they accumulate more value, remain free from federal gift and estate taxes for the life of the dynasty trust. Essentially, that means there are no federal taxes on distributions from the trust to you (the creator of the trust), distributions made to your descendants, distributions made at your descendants' death or distributions made when the dynasty trust ends.

As an illustration, imagine that you want to pass $10 on to your descendants without utilizing a dynasty trust. Assuming that $10 is subject to the highest estate tax rate of 55 percent that will kick in if Congress fails to act by 2013, your children would receive $5.50. Now, assume they want to pass wealth on to their children, and are also subject to a 55 percent tax rate; by the time it's in the hands of your grandchildren, that $5.50 is down to $2.47 after Uncle Sam's cut. Your great-grandchildren would receive only a paltry $1.11.

On the other hand, imagine you create a dynasty trust with that $10. You'll still be subject to taxes at your generational level if you have used up your federal tax exemption, but instead of being eaten away over time, the $5.50 you initially funded the dynasty trust with will grow. At a modest 6 percent annual rate of return, if your dynasty trust lasts for 90 years (many last even longer), your initial investment will be worth $1042 to your descendants at the expiration of the trust with no federal estate tax liability.

Proposed Durational Limits Make 2012 the Year to Create a Dynasty Trust

Dynasty trusts can be set up in many states. In most jurisdictions, dynasty trusts can last 21 years beyond the death of the last beneficiary alive at the time the trust was created. However, some jurisdictions, in an effort to attract generational wealth, are now offering perpetual dynasty trusts.

If you are considering a dynasty trust, it is important to act now. For one thing, if Congress does nothing, estate and gift tax exemptions are set to go down at the outset of 2013, and top rates are set to go up. In addition, a proposal to limit dynasty trusts to 90 years is currently being considered at the federal level. If this proposal is passed, it would apply to new trusts or additions of money to existing trusts, but not to those trusts already funded at the time of passage.

The time to act on a dynasty trust is now. If you want to find out more about providing for future generations of your family on a tax-free basis, talk to an experienced estate planning attorney today.

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