The term "death taxes" refers to two separate but interrelated taxes. An estate tax is imposed on the overall value of an estate—everything a decedent owns at the time of their death. Inheritance taxes are levied against each individual bequest made from an estate to a beneficiary. At least one type of trust is set up to avoid and alleviate these taxes.
The estate pays the estate tax, and the beneficiary pays the inheritance tax, although an estate can be set up to pay that cost, too, on behalf of the beneficiary.
Estates Can Be Taxed Twice
An estate asset can be taxed twice, once as part of the estate then again when it's transferred to a beneficiary, although not at the federal level.
The Gift Tax
The Internal Revenue Service doesn’t impose an inheritance tax, nor does it tax inheritances as income. Six states do tax inheritances as of tax year 2020, however, and one of them—Maryland—taxes both estates and inheritances. The others include:
- New Jersey
Your beneficiaries won't have to worry about an inheritance tax unless you live in one of these six states, or if the property they're receiving is located there. Beneficiaries who aren’t related to you pay the highest rates. Gifts to spouses are generally exempt.
The Estate Tax
Twelve states and the District of Columbia additionally impose their own estate taxes as of 2020:
- New York
- Rhode Island
An estate’s value must exceed $11.7 million as of 2021 before the balance is subject to estate taxes at the federal level, so most estates don't have to pay this tax. This exemption could possibly plummet back to the $5 million range in 2026, however, when the Tax Cuts and Jobs Act (TCJA) expires.
Estate tax exemptions at the state level tend to be much less than the federal exemption as well, so more estates could owe taxes in these jurisdictions.
Some Gifts Are Tax-Free
In most cases, you must give to a qualified charity if you're going to get any sort of tax break for being generous. The IRS offers a list of acceptable, qualified charities on its website. You can check it to make sure that the charity you’re considering is covered.
Your estate can claim a deduction for anything you bequeath to a qualified charity. Your gift won’t count toward the value of your estate for estate tax purposes, and you can claim a tax deduction on your personal return during your lifetime when you give the gift.
The Effect of Lifetime Giving
You'll want to keep an eye on federal gift tax rules if you’re giving to a friend or relative while you're still alive. This won't necessarily dodge the estate or inheritance tax rules.
Gifts you make during your lifetime are taxable to you, not to your beneficiaries as they would be if they were to inherit after your death. You can give away up to $15,000 per person per year without incurring the tax as of 2021.
This exclusion is indexed for inflation, but it can only increase in $1,000 increments, so it's rarely adjusted every single year. It's been set at $15,000 since 2018.
You can transfer a fair bit of money to your beneficiaries without incurring gift tax if you do this each year for an extended period of years, and you'll simultaneously reduce the value of your estate. Your beneficiaries won’t have to pay inheritance tax on the gifts if you live in a state that imposes one, because you’re still living.
You can subtract the excess of any gifts over the $15,000 per person per year annual exclusion from your $11.7 million estate tax exemption, but this will leave less of the exemption to cover your estate from estate taxation when you die.
Do Living Trusts Dodge Estate Taxes?
Trusts are legal entities that hold property that's eventually transferred to living beneficiaries at the time of the trustmaker’s death. They dodge the probate process but not necessarily estate taxes. There are two basic types of trusts.
A revocable trust—the more common kind—won’t avoid the estate tax. The term “revocable” is key here. The trustmaker acts as trustee and can undo the trust at any time. They can dissolve it, take property back out of its ownership, or change its beneficiaries. Any income generated by a revocable trust is reported and taxed on the trustmaker's personal tax return.
The trustmaker still legally owns the assets funded into the trust, so the IRS says it still contributes to the individual's estate for estate tax purposes when they die.
A trustmaker who forms an irrevocable trusts must step aside after they create it. They can’t act as trustee or maintain any control over the assets. They must appoint a third party to act as trustee. They give up ownership of the property funded into it, so these assets aren't included in the estate for estate tax purposes when the trustmaker dies.
Irrevocable trusts file their own tax returns, and they’re not subject to estate taxes, because the trust itself is designed to live on after the trustmaker dies.
An irrevocable trust can be a handy way to avoid estate taxes if your estate is large enough to be potentially liable for them, at both the state and federal levels.
Giving a Retirement Account
Retirement accounts can be tricky inheritances for your beneficiaries. Distributions from these accounts are generally taxable, and tax law is pretty strict about when distributions must be taken if you leave your accounts to anyone other than your spouse. Your 30-year-old child wouldn't be able to sit on the account for 35 years until their retirement, letting it grow and grow undisturbed.
In most cases, your beneficiary must begin taking distributions in the year after your death, and these distributions are taxable as income to them. Exactly how much they must take depends on the method of calculation they use. Distributions can be spread out, resulting in less taxable income per year, if they use the “single life” method. This is based on their own age and life expectancy, not yours.
If you leave your retirement account to your spouse, however, they can simply take it over. They wouldn’t have to begin taking required minimum distributions and paying taxes on those distributions until they reach age 70 1/2 or 72, depending on the year in which they reach age 70 1/2. The account would be treated just as if they had personally owned it all along.
The Unlimited Marital Deduction
All of these rules presume that you're not outright giving assets to your spouse, either during your lifetime as gifts or via your estate when you die. Spouses are protected by an unlimited marital deduction. You can give everything you own to your partner, or leave everything to them in your estate plan, and no tax will come due—with one exception.
Gifts to spouses who aren't U.S. citizens are limited to $157,000 a year as of 2020. This limit is also indexed for inflation, so it can increase periodically.
Capital Gains Taxes
Gifts to beneficiaries aren't usually taxable to them as income, but this doesn’t necessarily mean that they won't be subject to capital gains tax.
Consider this scenario: You leave the family home to your adult child. You paid $80,000 for it many decades ago. It’s worth $400,000 at the time of your death. Depending on where your home is located, your state might want a percentage of that $400,000 as an inheritance tax at the state level, although direct descendants are typically afforded the kindest rates.
Your child has a home of their own, and they don't want to sell it and move back into your home. Nor do they want to rent your home out and deal with being a landlord, so they decide to sell it. Capital gains tax is normally payable on the difference between an asset’s basis—what it cost to acquire it—and the ultimate sales price.
Not only will $385,000 of its value count against your $11.7 million estate tax exemption in the year you make the gift, but your child will receive your cost basis in the property as well if you give your $400,000 home as a gift during your lifetime. They'd have a $320,000 capital gain if they were to sell the property for $400,000.
They might not realize any gain, however, if you were to pass the home to them as part of your estate plan after your death. The basis is “stepped up” to date-of-death value for inheritances. They wouldn't realize a gain if the property were worth $400,000 on the date of your death, and they were to sell it for that amount.
The basis remains at your purchase price—$80,000 in this example—if you move the property into a living trust rather than give it directly to your beneficiary.
The executor of your estate can elect an alternate valuation date for purposes of calculating any estate taxes that might be due. This date is six months after your date of death. This value would be a stepped-up basis of your assets. It would favor your beneficiary if the property were to increase slightly in value during this time.
NOTE: Tax laws can change periodically, and the above information might not reflect the most recent changes. Please consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice, and it is not a substitute for tax advice.