Inheritance Tax and Estate Planning: What You Need to Know

Estate planning is the process of arranging your financial affairs to manage assets during your lifetime and determine their distribution after death. It is fundamentally linked to inheritance tax, which is a state-level tax paid by an individual who receives money or property from an estate. Through effective estate planning, you can structure your affairs to legally reduce the potential inheritance tax your beneficiaries might face, ensuring your assets are passed on in a way that aligns with your wishes.

Understanding Inheritance Tax

Unlike the federal estate tax, which is paid by a deceased person’s estate, an inheritance tax is paid by the beneficiaries. The responsibility for paying the tax falls on the person who inherits the assets. While the federal government does not have an inheritance tax, a handful of states do, and the laws of the state where the decedent lived determine if the tax applies.

As of 2025, the states that impose an inheritance tax are Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Iowa eliminated its inheritance tax as of January 1, 2025. In these states, tax rates and exemptions are directly tied to the beneficiary’s relationship to the deceased, which favors close family members.

A surviving spouse is exempt from inheritance tax in all states that levy it. Children and grandchildren also receive favorable treatment, often being fully exempt or facing a low tax rate above a certain threshold. In contrast, distant relatives and unrelated friends face significantly higher tax rates, sometimes as high as 15% or 16%, with smaller or no exemptions.

The tax is calculated on the value of the assets each beneficiary receives, so two beneficiaries of the same estate can have different tax obligations. Each beneficiary is responsible for filing a state inheritance tax return and paying any tax due. This is a separate filing from any returns the estate’s executor might file.

Core Estate Planning Documents

A Last Will and Testament is a legal document that outlines your wishes for distributing your property and the care of any minor children. It provides clear instructions for the probate court, which is the legal process for validating the will and overseeing the settlement of the estate.

A limitation of relying on a will is that it guarantees the estate will go through probate, a court-supervised process that can be time-consuming, expensive, and public. To avoid this, many people use trusts. A trust is a legal arrangement where a trustee holds and manages assets on behalf of beneficiaries.

Trusts come in two forms: revocable and irrevocable. A revocable living trust is created during your lifetime and can be altered or revoked at any time. Assets in a revocable trust pass directly to your designated beneficiaries upon death, bypassing probate for a private and efficient transfer.

An irrevocable trust, once created and funded, cannot be changed or dissolved by its creator. When you transfer assets into an irrevocable trust, you relinquish control and ownership. Because this removes the assets from your personal ownership and taxable estate, these trusts are powerful tools for asset protection and tax planning.

Strategies to Reduce Inheritance Tax

Effective estate planning can minimize the tax liabilities beneficiaries might face. Several strategies can reduce the size of an estate subject to state inheritance or federal estate tax by strategically transferring wealth.

Lifetime Gifting

Making gifts during your lifetime is a direct way to reduce a future taxable estate. Federal law allows you to give a certain amount of money to any number of individuals each year without incurring a gift tax. For 2025, this annual gift tax exclusion is $19,000 per recipient, and making such gifts removes those assets from your estate tax-free.

Beyond the annual exclusion is the larger lifetime gift and estate tax exemption, which is $13.99 million per individual for 2025. A person can give away up to this amount during their life or at death without federal gift or estate tax. Making gifts that exceed the annual exclusion uses up this lifetime exemption but also reduces the final value of your estate.

Using Irrevocable Trusts

An Irrevocable Life Insurance Trust (ILIT) is a type of trust created specifically to own a life insurance policy. As the grantor, you make annual gifts to the trust, and the trustee uses those funds to pay the policy premiums. Upon your death, the life insurance policy’s death benefit is paid directly to the trust, removing the proceeds from your taxable estate.

The proceeds are then distributed to the beneficiaries free from federal estate and state inheritance taxes, providing them with tax-free liquidity. These funds can be used to pay inheritance taxes due on other assets or cover estate settlement costs. This can prevent the need to sell family assets like a home or business to pay tax bills.

Charitable Planning

Making bequests to qualified charitable organizations can reduce the taxable value of an estate. Assets left to a registered charity are deducted from the estate’s total value before taxes are calculated. This supports causes you care about and can lower the estate’s value below the tax threshold.

This can be done through a bequest in a will or trust, or through a Charitable Remainder Trust (CRT). A CRT allows you to place assets into a trust that pays an income stream to you or others for a set term. The remainder of the trust assets then passes to a charity, which provides an immediate income tax deduction and removes the assets from your taxable estate.

The Estate Administration Process

After a person’s death, the estate administration process begins to settle their final affairs. If a will exists, the named executor is responsible for presenting it to the probate court for validation. The court then grants the executor the legal authority to act on behalf of the estate.

If the deceased person’s assets were held in a trust, the successor trustee assumes control without needing court approval. The trustee’s responsibility is to manage and distribute the trust’s assets according to its instructions. In either case, the executor or trustee must first identify and gather all of the deceased’s assets.

A part of administration is valuing all estate assets at their fair market value as of the date of death for tax purposes. The executor is responsible for filing the deceased’s final personal income tax return and an income tax return for the estate. If the estate’s value exceeds the federal exemption, the executor must also file a federal estate tax return.

After all debts, administrative expenses, and taxes of the estate have been paid, the executor or trustee makes the final distribution of the remaining assets to the heirs. This distribution is specified in the will or trust.