Trust vs. Inheritance Tax: What’s the Difference?
Explore how trusts function as a planning tool and their distinct interaction with the taxes paid by an estate versus those paid by a beneficiary.
Individuals planning their estates often hear the terms inheritance tax and trusts used interchangeably, which can lead to misunderstanding. These are distinct concepts in estate planning, each with its own rules and financial implications. Understanding their differences is an important step in developing a strategy for passing assets to the next generation.
Understanding Inheritance Tax
Inheritance tax is a state-level tax imposed on an heir or beneficiary when they receive assets from a deceased person’s estate. There is no federal inheritance tax in the United States; it is exclusively a matter of state law. As of 2025, only Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania levy this type of tax.
A feature of inheritance tax is that the tax rate is determined by the beneficiary’s relationship to the decedent. Spouses are exempt from this tax in all states that impose it. Direct descendants, such as children and grandchildren, often face very low or zero tax rates, while relatives like siblings might be taxed at a higher rate. The highest tax rates are applied to inheritances received by unrelated individuals.
Each state with an inheritance tax has its own set of exemption amounts and rate structures. For example, a nephew might only receive a $1,000 exemption before the tax applies, while an adult child might have a much larger exemption. These exemptions dictate the value of property that can be received before any tax is due.
Understanding Trust Taxation
There is no specific tax called a “trust tax.” Instead, the taxation of a trust depends on its structure, with the primary distinction being between revocable and irrevocable trusts. A revocable trust allows the grantor to retain control over the assets and make changes at any time. For tax purposes, assets in a revocable trust are treated as if they still belong to the grantor and remain part of the grantor’s taxable estate upon death.
An irrevocable trust cannot be altered or terminated by the grantor once established. When a grantor transfers assets into an irrevocable trust, they relinquish control and ownership. This action removes the assets from the grantor’s taxable estate, which is a common strategy for reducing potential estate tax liability.
Income generated by trust assets is also subject to taxation, reported to the IRS on Form 1041. If the trust retains the income it earns, the trust itself pays the income tax. If the trust distributes its income to the beneficiaries, the tax liability passes to them, and they receive a Schedule K-1 detailing the income to report on their personal tax returns.
The Federal Estate Tax Explained
The federal estate tax is a tax on the transfer of a person’s assets after death. Unlike an inheritance tax paid by beneficiaries, the estate tax is paid by the decedent’s estate before assets are distributed. The tax is calculated on the net value of all assets the person owned at the time of death, such as cash, real estate, and stocks.
A feature of the federal estate tax is its high exemption amount, which is $13.99 million per individual for 2025. An estate will not owe federal estate tax unless its total value exceeds this threshold. For married couples, this exemption is doubled to $27.98 million.
Because of this exemption, most estates in the United States do not owe federal estate tax. Only the portion of an estate’s value that exceeds the exemption amount is subject to the tax, with a maximum rate of 40%. Some states also impose their own estate tax, which often has a lower exemption threshold than the federal one.
How Trusts Interact with Estate and Inheritance Taxes
Trusts are not a way to avoid all taxes, but they can be used to manage and minimize them. The impact a trust has depends on the type of tax and the structure of the trust.
Regarding estate taxes, an irrevocable trust can be an effective tool for tax reduction. Since assets in an irrevocable trust are removed from the grantor’s estate, this can lower the estate’s total value. If this brings the value below the federal or a state-level exemption, it can eliminate the estate’s tax liability.
The situation is different for inheritance taxes, as a trust does not automatically shield a beneficiary from this tax. If a beneficiary in a state with an inheritance tax receives a distribution from a trust, they may be required to pay tax on the assets. The trust acts as the delivery mechanism, and the tax is triggered by the beneficiary’s receipt of the assets.