An intentionally defective grantor trust is one possible way you could pass on wealth in California. This type of trust allows the grantor to pay the income tax, where its name comes from, and avoid paying excessive estate taxes.
Estate tax
Intentionally defective grantor trusts (IDGT) aren’t subject to federal estate tax. When you deposit assets into the IDGT, they are no longer part of your estate. IDGT is a wealth transfer strategy that some people like to use because it helps them avoid reaching the estate tax limit. As of 2022, the cap was $12.06M per person. You could pass on that amount tax-free to an individual. IRS taxes anything over that amount at a 40% rate. An exception is a tax-free wealth transfer to a surviving spouse who would receive the estate. Charities are another type of beneficiary that doesn’t need to pay estate tax.
Gift tax
Contributions to an IDGT are subject to gift tax rules. You have a lifetime amount that you could give to beneficiaries tax-free. When you exceed your limit, then you would have to pay tax. California doesn’t charge a gift tax, but the federal government does. Certain types of gifts don’t incur a surcharge. For example, they are exempt if you set aside assets for education or medical expenses.
Income tax
Non-grantor trusts have to pay income tax higher than individual income tax. However, with an IDGT, the grantor chooses to pay income tax during their lifetime to prevent the trust from taxation after their death. Paying the taxes during their lifetime could reduce the overall cost of passing on the assets.
Intentionally defective grantor trusts are close to tax-free. They may help reduce the tax impact on your wealth distribution, so they are worth considering.