Understanding inheritance taxes

Strategies and steps to minimize their financial impact

Estate planning is something everyone should think about, even if you don't think you're "rich enough" to leave a big estate after you pass away. The fact is, a little planning can undoubtedly have a positive impact on your beneficiaries – family members and others who receive an inheritance. So, whether you’re leaving assets or looking to inherit them, if you want to minimize the portion that goes to the government, it helps to understand the tax implications. This article will tell you about:

The different kinds of taxes that may apply to inheritance
How various types of assets may be taxed
Common-sense ways to protect assets and minimize taxation

Estates, inheritances, and four kinds of taxes you could owe

What is an estate? The term refers to all the assets, property, and debts left behind by an individual at their death. This includes real estate, personal belongings, investments, and any other tangible or even intangible assets such as a patent or other intellectual property. The value of an estate also encompasses any outstanding liabilities or debts that need to be settled before the distribution of the remaining assets.

1. Estate taxes:

It's important to understand that estate taxes (when applicable) are levied on the transfer of the estate before it is distributed to heirs. In practical terms, that means the estate pays any taxes owed, not the beneficiaries who receive assets. But even though heirs don’t pay estate taxes, they take away from any assets or funds they would otherwise have inherited.

Currently, most estates aren’t subject to federal estate taxes, which is good news because they can be as high as 40%.¹That's because according to the Tax Cuts and Jobs Act (TCJA) of 2017, there's a lifetime gift and estate tax exemption set at $$13.99 million per individual for 2025.²In other words, you can leave almost $14 million to your heirs without worrying about federal estate taxes. But that will soon change.

The Tax Cuts and Jobs Act is set to expire at the end of 2025, and unless Congress takes action, the federal estate tax exemption will revert to its pre-2018 level: $5.49 million, with adjustments for inflation.³ So, if you own a house, business, or farm or have just saved diligently for retirement, there's a fair chance that your estate could cross that threshold and be subject to federal estate taxes if you pass away after 2025.

Many states also impose their own estate taxes. In other words, the state you reside in at the time of your death matters, because it can take additional taxes from your estate. Rules, tax rates and exemption thresholds vary greatly, so it’s important to discuss estate planning strategies with a tax or finance professional who knows the laws in your jurisdiction. States that impose estate taxes include:⁴

Connecticut
Hawaii
Illinois
Maine
Maryland
Massachusetts
Minnesota
New York
Oregon
Rhode Island
Vermont
Washington, D.C.
Washington

2. Inheritance taxes:

Currently, six states (but not the federal government) also impose taxes on inheritance — the portion of an estate that is passed on to a specific beneficiary. The value of an inheritance can include money, property, or personal items of value, and inheritance taxes are not paid by the estate; they are paid by the beneficiary who receives it, even if they don't live in that state. Only one state — Maryland — imposes both an estate and inheritance tax.

Inheritance tax rules vary by state, the size of the inheritance, and even the beneficiary's relationship to the deceased: spouses and children typically pay less than distant family members and non-relatives. Again, it’s important to discuss inheritance tax strategies with a tax or finance professional who knows the laws in your jurisdiction. The six states that impose inheritance taxes are:⁵

Iowa (phasing out in 2025)
Kentucky
Maryland
Nebraska
New Jersey
Pennsylvania

3. Capital gains tax:

When you sell assets like stocks, real estate, or other investments that have appreciated in value, you typically have to pay capital gains tax on the increase in value. So, for example, if your grandparent leaves you $10,000 of stock, and you decide to sell it after a few years for $12,000, you would typically owe federal (and possibly state) capital gains tax on the $2000 "capital gain" or profit.

Fortunately, when you inherit an appreciating asset like shares of stock, you typically benefit from a "stepped-up cost basis." In other words, even if that grandparent initially purchased the shares for $1,000, your taxes aren't based on that initial value; they are based on the cost (hence the term "cost basis") of $10,000 at the time you inherited the shares.

4. Income tax:

Most inherited assets, and even benefits from a life insurance policy, aren’t subject to ordinary income taxes. But there’s an exception for certain distributions from retirement accounts, such as an IRA or 401(k). Contributions to these “qualified” accounts are made with pre-tax dollars, but withdrawals are typically taxed as ordinary income. A beneficiary can choose to roll these retirement funds over into their own IRA account, but their withdrawals in retirement will then be subject to income taxes.

Different kinds of assets have distinct tax implications

Part of the estate planning process involves looking at your different types of assets and thinking about how they will be distributed. There are a variety of tax implications to consider with your tax and estate planning advisors, as well as strategies for mitigating their impact.

Stocks – When you pass away, the value of your stock holdings becomes part of your taxable estate. This can increase your estate's total worth, potentially pushing it over state and federal thresholds that trigger tax liabilities. However, you can give stock shares away while you're alive, reducing the overall value of your estate. Consistent, strategic gifting (see below) can be an important part of your strategy.

Cash — Cash and "cash equivalents," such as CD savings accounts, are liquid assets included in the total valuation of your estate. As with stock holdings, a large amount of cash can elevate the estate's value above tax exemption thresholds, increasing tax liabilities. Good estate planning should include strategies to manage cash holdings to ensure sufficient liquidity for the estate's needs while minimizing tax implications – for example, through strategic gifting.

Retirement accounts — Generally, retirement accounts such as 401(k)s and Individual Retirement Accounts (IRAs) are subject to taxation upon distribution to beneficiaries, potentially increasing the overall income tax liability after your death. Strategically managing required minimum distributions (RMDs) during your lifetime can help reduce your taxable estate and provide liquidity for estate settlements.

Life insurance — Life insurance policies can play an important role in estate planning because policy proceeds paid to beneficiaries are generally not taxed or considered part of the estate. Benefit payments also bypass the probate court process, meaning that needed funds can be available more quickly. However, it's important to pay attention to the beneficiary designations in any life insurance policies: if your estate is named as the beneficiary, the proceeds from the policy can significantly increase the size of your estate, potentially elevating it above tax exemption limits.

Real estate — As tangible assets, properties contribute significantly to the total value of your estate, which directly influences the tax obligations upon inheritance. Generally, the assessed fair market value of the real estate at the time of your death is included in your taxable estate, which can trigger tax liabilities and potentially force a sale. The more real estate you own, the more you need to work with your advisors to create a family that keeps essential properties intact for your heirs.

Art and collectibles — These assets often appreciate over time, and their value could increase the taxable amount of your estate, pushing it beyond tax exemption thresholds. It's important to accurately inventory and determine the value of your art and collectibles during estate planning. Many donate portions of their collection to charitable institutions as a way to help manage their overall tax liabilities.

Considerations and strategies for minimizing tax implications

The more you have, the more critical it is to start the estate planning process early, while you still have time to put strategies in place to better manage the transfer of your assets to the loved ones and causes you care about most. As you are discussing your wishes with your tax and financial professionals, consider asking about the following:

Gifting during your lifetime

For tax purposes, a gift is the transfer of property or assets by one person to another without receiving something of equal value in return. Giving away assets during your lifetime can help reduce the overall size of your estate, but it has to be done the right way.

Under current tax laws, when one person gives a large gift to another – for example, a car worth $30,000 – the gift giver (not the receiver) is liable for taxes. However, such gifts are counted against the same lifetime threshold as estate taxes. That's why it's called the "lifetime gift and estate tax exemption," which, as noted earlier, is set to revert to $5.49 million (with an adjustment for inflation) after 2025.

However, you can use gifts to minimize the ultimate value of your estate – and potentially keep it under tax thresholds – by taking advantage of the annual gift tax exclusion. Current tax law allows each individual to give away a certain amount of assets each year income tax-free without having it count against their lifetime gift and estate tax exemption. For 2025, the annual gift tax exclusion is $19,000, which means that you can give that amount – to as many people as you want – without ultimately having to pay taxes on the gifts.⁶ If you are married, then as a couple, you can give $38,000 to a single person under the exemption. Furthermore, if you give the maximum to each of four children or grandchildren for ten straight years, you can lower the ultimate value of your estate by 1,520,000.

Marital deduction

This deduction allows for the unlimited transfer of assets between spouses without incurring estate taxes, which has the effect of deferring taxation until the surviving spouse's death. However, care needs to be taken for those with large estates looking to take advantage of both partners' lifetime gift and estate tax exemptions: while assets can be transferred, lifetime exemptions cannot.⁷ However, a knowledgeable estate planning professional can help such couples take steps to mitigate these concerns.

Setting up or contributing to a 529 plan

A 529 plan, which is a tax-advantaged savings account designed to encourage saving for future education costs, can help reduce the taxable value of an estate while simultaneously investing in the education of your children, grandchildren or other family members. Contributions to a 529 plan are considered completed gifts to the beneficiary, meaning they are removed from the contributor's estate. However, it’s important to remember that contributions over the annual gift tax exclusion 19,000 per individual in 2025) are counted toward the lifetime gift and estate tax exemption.

Charitable donations

Just as charitable giving can provide an income tax deduction that helps you minimize your personal tax burden, contributions to qualified charitable organizations can reduce estate tax liability, providing both tax benefits and supporting philanthropic goals. Importantly, donations to qualified charities are not typically counted against your lifetime gift and estate tax exemption.⁸

Leaving assets to grandchildren, and the Generation-Skipping Transfer Tax (GSTT)

This tax primarily targets very large estates looking to avoid double estate taxation as assets are passed from grandparents to adult children, then on to grandchildren. When wealth is transferred to a "skip person," such as a grandchild or an unrelated individual more than 37.5 years younger than the donor, the GSTT is levied in addition to any applicable gift or estate taxes.⁹ There are specific exceptions and planning strategies, such as utilizing the GST exemption, which allows individuals to transfer a set amount of assets without incurring GST tax.

Trusts

Trusts are often used by the wealthy for estate tax purposes, but they can be valuable even if you aren’t rich, especially if you have young children or children with special needs and want to control access to your assets if you die unexpectedly.

Generally speaking, a trust used for estate planning purposes is either irrevocable or revocable. In either case, the trust owns the assets it holds, the trustee manages those assets while you (the grantor) are alive, then oversees the distribution of trust assets to trust beneficiaries following your death. Both types of trusts share similar ownership and general management conditions, but a revocable trust offers much more flexibility and control over your assets, while an irrevocable trust offers more ways to lower estate valuations and avoid taxation thresholds.

However, it's important to understand that each trust is a unique and highly detailed legal entity designed to navigate complex tax laws and regulations. So, it's essential to work with an experienced estate planning attorney who can help you understand the tax implications and ensure that the trust is structured in a way that helps mitigate your specific tax liabilities and achieve the estate planning goals you want to achieve. Different types of trusts to consider include:

Irrevocable Life Insurance Trust (ILIT) — This is a specialized trust designed to hold a life insurance policy outside of your estate, so that the proceeds aren’t subject to estate taxes. By placing your policy into an ILIT, you relinquish ownership, so the policy is not included in the taxable estate upon death. This setup provides the beneficiaries with the full insurance payout without the reduction by estate taxes and is often used to fund a special needs trust to care for offspring with disabilities.
Qualified Personal Residence Trust (QPRT) — This allows you to transfer a primary or secondary residence into the trust, while retaining the right to live there for a set number of years. During this time, the home's value is removed from your estate, potentially reducing estate taxes upon your death. After that term, if you want to continue living in the home, you typically pay rent to your beneficiaries, which helps further reduce your taxable estate.¹⁰
Intentionally Defective Grantor Trust (IDGT) – This is a type of irrevocable trust in which you continue to pay income taxes on the income generated by the trust, reducing your taxable estate without incurring gift tax on appreciated asset transfers. By selling assets to the IDGT in exchange for a promissory note, you can remove these assets from your estate, allowing any future appreciation to benefit the trust beneficiaries. This is often used by very high-net-worth individuals seeking to leverage asset appreciation while minimizing gift and estate taxes.¹¹

Family Limited Partnership (FLP)

This legal entity is actually a type of business formed by family members who contribute assets to the partnership, with one or more family members acting as general partners and the others as limited partners. While quite complex, an FLP can be an effective way to transfer wealth to heirs at a reduced gift and estate tax cost because rules for these limited partnership shares can reduce their value for tax purposes.¹²

Taking the next step

Whether you are planning for your own estate or expecting to become a beneficiary of someone else's, this knowledge can help you take actions now that can help minimize unwanted estate or inheritance taxes later. But it's important to remember that while there are numerous ways to reduce the burden of estate taxes, the strategy, or combination of strategies, that will work best for your long-term financial planning is best determined with the help of your tax advisor and a dedicated estate planning professional.