What Is a Wealth Transfer Tax and How Does It Work?

A wealth transfer tax is a levy imposed on the passage of assets from one person to another. It is an umbrella term for taxes that apply when property is given away, either during a person’s lifetime or after their death. These taxes target the value of assets as they move between individuals, including cash, real estate, stocks, and business interests. They are distinct from income or property taxes, which are levied on earnings or the value of assets held.

Components of the Federal Wealth Transfer Tax System

The federal government’s approach to taxing wealth transfers is built on three distinct but interconnected taxes. Each serves a specific purpose, ensuring that transfers of significant wealth are taxed whether they occur during life or at death.

The Federal Estate Tax

The federal estate tax is levied on a person’s “gross estate” after they pass away but before assets are distributed to heirs. An individual’s estate encompasses all property they own or have a controlling interest in at the time of death, including cash, securities, real estate, and business interests. The tax is calculated on the net value of the estate after certain deductions are taken. It is paid by the decedent’s estate itself, not by the individuals who inherit the assets, and only applies to the value that exceeds a high exemption level set by law.

The Federal Gift Tax

The federal gift tax applies to transfers of property a person makes while they are alive. A gift is any transfer to an individual where fair market value is not received in return. The tax is the responsibility of the donor, the person making the gift, and the recipient does not have to report the gift as income. This tax was established to prevent individuals from avoiding the estate tax by giving away their assets before death.

The Generation-Skipping Transfer (GST) Tax

The Generation-Skipping Transfer (GST) tax is a supplemental tax on transfers of wealth to individuals two or more generations younger than the donor. This person, known as a “skip person,” is often a grandchild or a non-relative who is more than 37.5 years younger than the transferor. The GST tax was enacted to prevent families from avoiding an estate tax by leaving assets directly to grandchildren. It is imposed at the highest federal estate tax rate and applies in addition to any federal gift or estate tax due on the same transfer.

Key Exemptions and Exclusions

The Unified Credit (Lifetime Exemption)

The unified credit, or lifetime exemption, is a combined credit that applies to both gifts made during one’s lifetime and assets transferred at death. For 2025, the lifetime exemption is $13.99 million per individual. This means a person can transfer up to this amount in total before any federal estate or gift tax is owed.

When a person makes a taxable gift, the amount of that gift reduces the lifetime exemption available to their estate. For example, a $1 million taxable gift would reduce the remaining exemption by that amount. Under current law, this high exemption amount is scheduled to be reduced significantly at the end of 2025.

Portability

Portability allows a surviving spouse to use any unused portion of their deceased spouse’s lifetime exemption. This provision, known as the Deceased Spousal Unused Exclusion (DSUE), lets a married couple combine their exemptions. For example, if the first spouse to die uses only $5 million of their $13.99 million exemption, the surviving spouse can add the remaining $8.99 million to their own. To secure portability, the executor of the deceased spouse’s estate must file a federal estate tax return (Form 706) and make the election. This election is not automatic and must be made on a timely filed return.

The Annual Gift Tax Exclusion

The tax code provides an annual gift tax exclusion in addition to the lifetime exemption. For 2025, an individual can give up to $19,000 to any number of recipients without gift tax consequences. These gifts do not have to be reported and do not reduce the donor’s lifetime exemption. A married couple can combine their annual exclusions to give up to $38,000 per recipient in 2025 through “gift splitting.” For instance, a couple could give $38,000 to each of their three children for a total of $114,000 in one year without using any of their lifetime exemption.

Unlimited Marital and Charitable Deductions

The tax code allows for unlimited deductions for certain transfers, making them exempt from gift or estate taxes. The unlimited marital deduction permits an individual to transfer an unrestricted amount of assets to their U.S. citizen spouse, during life or at death, tax-free. This defers any potential tax until the death of the surviving spouse. Similarly, an unlimited charitable deduction is available for transfers made to qualified charitable organizations, as outlined in the Internal Revenue Code. Any amount given to a qualifying charity is fully deductible from the estate, reducing its taxable value.

Calculating the Taxable Transfer

For an Estate

The calculation for an estate begins with determining the “Gross Estate,” which is the fair market value of all assets the decedent owned at death. This includes cash, real estate, investments, and insurance proceeds. From this total, allowable deductions are subtracted to arrive at the “Taxable Estate.” These deductions can include mortgages, debts, funeral expenses, and administration costs. Once the taxable estate is calculated, the decedent’s remaining lifetime exemption is applied, and any value exceeding the exemption is taxed at a flat 40% rate.

For a Gift

The calculation for a lifetime gift starts with the total value of gifts made to one person in a year. From this amount, the annual exclusion is subtracted, and the remainder is a “taxable gift.” For example, if you give someone $50,000 in 2025, the taxable portion is $31,000 ($50,000 – $19,000 annual exclusion). This taxable gift must be reported to the IRS on Form 709 and is subtracted from the donor’s lifetime exemption. No gift tax is paid unless the donor’s lifetime exemption has been fully used.

State-Level Estate and Inheritance Taxes

Beyond the federal system, some states impose their own wealth transfer taxes, which are separate from any federal tax liability. States use one of two structures: an estate tax, which is paid by the decedent’s estate, or an inheritance tax, which is paid by the beneficiaries who receive the property. Exemption amounts and tax rates vary significantly by state.

Twelve states and the District of Columbia impose an estate tax:

• Connecticut
• Hawaii
• Illinois
• Maine
• Maryland
• Massachusetts
• Minnesota
• New York
• Oregon
• Rhode Island
• Vermont
• Washington

A smaller number of states levy an inheritance tax:

• Kentucky
• Maryland
• Nebraska
• New Jersey
• Pennsylvania

Maryland is the only state that imposes both an estate and an inheritance tax. Inheritance tax rates often depend on the relationship of the heir to the decedent, with closer relatives paying lower rates.

Common Wealth Transfer Planning Vehicles

Irrevocable Trusts

An irrevocable trust is a common planning tool where a grantor permanently transfers ownership of assets to the trust. Because the grantor gives up control, the assets are removed from their taxable estate and will not be subject to estate tax upon death. The trust is a separate legal entity managed by a trustee for the named beneficiaries. Once established, the trust cannot be altered or revoked by the grantor, which is the trade-off for the tax benefits.

Specific Trust Examples

An Irrevocable Life Insurance Trust (ILIT) is created to own a life insurance policy. By having the ILIT own the policy, the death benefit proceeds are paid to the trust instead of the grantor’s estate, excluding them from estate taxation. The trustee uses funds gifted to the trust to pay the policy premiums.

Another tool is the Grantor Retained Annuity Trust (GRAT), which allows a grantor to transfer appreciating assets into a trust while receiving an annuity payment for a set term. At the end of the term, any appreciation above an IRS-set interest rate passes to beneficiaries free of gift tax.

Systematic Gifting

A common strategy involves the consistent use of the annual gift tax exclusion. By making gifts each year at or below the annual exclusion amount, an individual can transfer substantial wealth over time without tax consequences. These gifts do not require filing a gift tax return and do not reduce the donor’s lifetime exemption. This approach is effective for transferring appreciating assets, as all future growth occurs outside of the donor’s estate. For example, gifting shares of stock allows the recipient to benefit from future increases in value that would have otherwise been part of the donor’s taxable estate.