Estate Planning and Taxes: What You Need to Know

Estate planning is the process of arranging for the management and disposal of your assets during life and after death, with the core objective of transferring property according to your wishes while minimizing tax liabilities. This planning is not solely for the wealthy; anyone who owns property can benefit from a clear plan to provide for loved ones, reduce administrative burdens, and preserve the value of their estate.

Understanding Key Estate-Related Taxes

The federal estate tax is a tax on the transfer of a person’s assets after death, paid by the estate itself. For 2025, an estate is exempt if its value is below the $13.99 million lifetime exemption. Due to this high exemption, most estates in the U.S. do not owe federal estate tax.

Some states impose their own estate tax, separate from the federal system. As of 2025, twelve states and the District of Columbia levy an estate tax: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington. The exemption amounts for these state taxes are often much lower than the federal exemption, meaning more estates are subject to them.

Inheritance tax is levied on the beneficiaries after they receive assets from an estate. This tax is not imposed at the federal level but is used by a few states. As of 2025, the states with an inheritance tax are Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The tax rate often depends on the beneficiary’s relationship to the decedent; spouses are often exempt, while more distant relatives may face higher rates.

The gift tax is linked to the estate tax through the lifetime exemption. In 2025, you can give up to $19,000 to any individual under the annual gift tax exclusion. Gifts below this amount do not need to be reported to the IRS and do not reduce your lifetime exemption. This allows for tax-free transfers of assets during your lifetime.

Calculating the Taxable Estate

To determine if estate tax is owed, you must calculate the taxable estate. This starts with valuing all assets owned by the decedent at death, which form the “gross estate.” Assets include cash, stocks, real estate, business interests, and personal property. Life insurance proceeds are also included if the decedent owned the policy.

After calculating the gross estate, several deductions are subtracted to determine the final “taxable estate.” Allowable deductions include:

• The decedent’s debts, such as mortgages, personal loans, and credit card balances.
• Funeral expenses and estate administration costs, including fees for attorneys, executors, and court filings.
• Transfers to a surviving spouse who is a U.S. citizen, which are covered by the unlimited marital deduction.
• Donations made to qualified charitable organizations, which are fully deductible.

Core Tax-Reduction Strategies in Estate Planning

A planned program of gifting can reduce a future taxable estate. By using the annual gift tax exclusion, an individual can transfer wealth over time without diminishing their lifetime estate tax exemption. A married couple can combine their exclusions to give double the amount per recipient annually, lowering the value of their eventual gross estate.

Certain payments made directly to institutions for another person are not considered taxable gifts. If you pay an individual’s tuition directly to an educational institution or their medical expenses to a healthcare provider, these amounts are unlimited. They do not count against the annual or lifetime gift tax exemptions.

Trusts are a common estate planning tool with varied tax implications. A revocable living trust is effective for avoiding probate but does not offer estate tax savings. Because the person who creates the trust (the grantor) retains control over the assets, the IRS views those assets as part of the grantor’s taxable estate.

An irrevocable trust can be a tool for tax reduction. When assets are transferred to an irrevocable trust, the grantor gives up control and ownership. This action can remove the assets and any future appreciation from the grantor’s taxable estate. An Irrevocable Life Insurance Trust (ILIT), for example, is designed to own a life insurance policy and keep the death benefit out of the taxable estate.

For married couples, using the unlimited marital deduction defers estate tax. This strategy allows one spouse to leave all assets to the surviving spouse without tax at the first death, deferring liability until the second spouse’s death. This is enhanced by “portability,” a provision allowing a surviving spouse to use the deceased spouse’s unused federal estate tax exemption. An estate tax return must be filed for the deceased to elect portability, even if no tax is owed.

Charitable planning can also reduce estate taxes. Making bequests to qualified charities in a will or trust reduces the taxable estate, as these transfers are fully deductible. More advanced strategies, like a Charitable Remainder Trust (CRT), allow you to transfer assets to a trust that pays you an income stream for life, with the remainder passing to a charity upon your death.

The Role of Asset Basis in Estate Planning

A related tax consideration is an asset’s “cost basis,” its original purchase price. This figure is used to determine capital gains tax when an asset is sold. The rules for basis differ depending on whether an asset is inherited or received as a gift, creating different income tax consequences for beneficiaries.

When an heir inherits an asset, they receive a “step-up in basis.” This rule adjusts the asset’s cost basis to its fair market value on the date of the original owner’s death. For example, if stock bought for $10 is worth $100 on the day the owner dies, the heir’s new basis is $100. The heir could then sell that stock for $100 without owing capital gains tax on the $90 of appreciation.

The treatment of gifted assets is different. When an individual receives an asset as a gift, they also receive the donor’s original cost basis, a concept known as “carryover basis.” If stock purchased for $10 is gifted when its value is $100, the recipient’s cost basis is still $10. If the recipient then sells the stock for $100, they would pay capital gains tax on the $90 gain.

This distinction creates a trade-off in estate planning. Gifting assets during one’s lifetime can reduce the size of a taxable estate, but it gives the recipient a low cost basis and a future capital gains tax liability. Holding onto appreciated assets until death allows heirs to benefit from the step-up in basis, potentially eliminating a large income tax burden for them.