What Is the Best Way to Leave Inheritance Without Tax?

The transfer of assets, whether during one’s lifetime or after death, can trigger significant tax consequences at both the federal and state levels. Understanding the framework of these taxes is the first step toward structuring an inheritance that maximizes the amount received by beneficiaries. The goal is to utilize available exemptions, exclusions, and planning tools to legally reduce the tax burden and preserve your financial legacy.

Understanding Federal Estate and Gift Tax Exemptions

The federal government imposes a tax on the transfer of wealth, which applies to assets given away during life (the gift tax) and assets left to heirs at death (the estate tax). These two taxes are linked by a unified credit, a lifetime exemption amount that an individual can use to offset these taxes. For 2025, the federal lifetime gift and estate tax exemption is $13.99 million per individual, meaning a person can transfer up to this amount without incurring federal estate or gift tax.

This exemption amount was established by the Tax Cuts and Jobs Act of 2017 but is scheduled to sunset at the end of 2025. If no new legislation is passed, the exemption will revert to its previous level, estimated to be around $7 million per individual, adjusted for inflation, starting in 2026. This potential reduction highlights the time-sensitive nature of current estate planning.

For married couples, “portability” allows a surviving spouse to use any of their deceased spouse’s unused lifetime exemption. This is not an automatic process; the executor of the deceased spouse’s estate must make a portability election on a timely filed federal estate tax return, even if no tax is owed. This election combines the exemptions, allowing the surviving spouse to shelter a larger amount of assets from estate tax.

The unlimited marital deduction permits the transfer of an unlimited amount of assets to a surviving spouse who is a U.S. citizen without any federal gift or estate tax. While this defers the tax, it does not eliminate it, as the assets will then be part of the surviving spouse’s estate. Planning often involves using this deduction with portability and the lifetime exemption to optimize the tax outcome.

Strategic Gifting During Your Lifetime

A direct way to reduce a future taxable estate is through lifetime gifting. The federal government provides an annual gift tax exclusion, allowing individuals to give a certain amount to any number of people each year without tax consequences. For 2025, this annual exclusion is $19,000 per recipient, and these gifts must be completed by December 31 to count for that tax year.

Married couples can combine their annual exclusions through gift splitting, allowing them to give up to $38,000 per recipient in 2025. This strategy can transfer a substantial amount of wealth out of the parents’ estates over time. For example, a couple with three children and five grandchildren could transfer up to $304,000 annually ($38,000 x 8) completely free of gift tax.

Beyond the annual exclusion, direct payments for tuition and medical expenses are unlimited and not subject to gift tax. To qualify, the payment must be made directly to the educational institution for tuition or to the medical facility for care. Payments made to an individual to reimburse them for these expenses do not qualify for this exclusion.

When a gift surpasses the $19,000 annual limit, the excess amount is counted against the giver’s $13.99 million lifetime exemption. While this uses up a portion of the lifetime exemption, it can be a powerful planning tool. Gifting assets like stocks or real estate that are expected to appreciate allows all future growth in the value of that asset to occur outside of the donor’s estate, shielding that appreciation from future estate tax.

Utilizing Trusts for Tax Efficiency

Trusts offer a sophisticated method for transferring wealth with more control and tax planning. An irrevocable trust involves the grantor permanently relinquishing control and ownership of the assets placed within it. This legal separation allows the assets, and any future appreciation, to be removed from the grantor’s taxable estate. Once assets are transferred to an irrevocable trust, the terms cannot be changed, and the assets are managed by a trustee for the beneficiaries.

Several types of irrevocable trusts are designed for specific tax-saving purposes. An Irrevocable Life Insurance Trust (ILIT) is created to own a life insurance policy. By having the trust own the policy, the death benefit is paid to the trust, keeping the proceeds out of the deceased’s taxable estate and providing tax-free liquidity to beneficiaries.

A Grantor Retained Annuity Trust (GRAT) is another vehicle used to transfer wealth. The grantor places assets into the GRAT and receives a fixed annuity payment for a set number of years. If the assets in the trust appreciate at a rate higher than the IRS-mandated interest rate, the excess appreciation passes to the beneficiaries at the end of the trust term, free of gift tax.

Charitable Remainder Trusts (CRTs) allow individuals to support a charity while achieving tax benefits. A grantor transfers assets to a trust, which provides an income stream to the grantor or other beneficiaries for a set term. At the end of the term, the remaining assets are distributed to a designated charity. This strategy removes the asset from the grantor’s taxable estate and can also provide the grantor with a current income tax deduction.

The Role of Life Insurance in Estate Planning

Life insurance provides immediate, income-tax-free cash to beneficiaries upon the death of the insured. However, the proceeds are included in the deceased’s taxable estate if the deceased individual owned the policy or retained rights like changing beneficiaries or borrowing against the policy. This can increase the estate’s tax liability.

To prevent the life insurance payout from increasing the taxable estate, the policy should be owned by an Irrevocable Life Insurance Trust (ILIT). As a separate legal entity, the ILIT becomes the owner and beneficiary of the policy. The insured makes annual gifts to the trust, which the trustee uses to pay the premiums, ensuring the death benefit is not part of their estate.

For an ILIT to be effective, the trust must be irrevocable, and the grantor cannot act as the trustee. When structured correctly, the ILIT ensures the full death benefit is available to the trust’s beneficiaries without being reduced by estate taxes. This liquidity can be used to pay any estate taxes, settle debts, or provide financial support for the family. This prevents the need to sell other, less liquid estate assets, such as a family business or real estate, to cover these immediate financial obligations.

Navigating State Estate and Inheritance Taxes

Individuals must also consider taxes imposed at the state level, which can affect an inheritance. A number of states levy their own taxes on wealth transfers, often applying to estates of a much lower value than the federal exemption. This means an estate not large enough to trigger federal tax may still be subject to a state tax bill.

A state estate tax is levied directly on the deceased person’s estate before assets are distributed. The states that currently impose an estate tax include:

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

In contrast, a state inheritance tax is paid by the beneficiaries who receive the assets. The tax rate often depends on the heir’s relationship to the deceased, with closer relatives paying a lower rate. The states with an inheritance tax are:

• Kentucky
• Maryland
• Nebraska
• New Jersey
• Pennsylvania

Maryland is unique as it imposes both an estate and an inheritance tax. Because state-level exemptions are lower and rules vary, planning for these taxes is a necessary step. Strategies used to mitigate federal taxes can also be effective at the state level, but consulting with a professional knowledgeable about specific state laws is advised.