When someone dies, their assets are transferred to any heirs. In some cases, this is a taxable event. The transfer of wealth could trigger estate taxes, which are paid by the estate of the deceased person. Or it could trigger inheritance taxes, which are paid by those who inherit money.
Estate taxes could be charged on either the federal or state level, whereas inheritance taxes are charged only by a limited number of states. Fortunately, with the right tax planning and estate planning, it might be possible to avoid either type of so-called death tax.
Here's what you need to know about how to avoid inheritance tax that either you or your heirs might have to pay.
In this article
- What is inheritance tax?
- 8 ways to avoid inheritance tax
- Start planning now to reduce your tax burden
- Bottom line
What is inheritance tax?
Estate tax and inheritance tax are both taxes that are sometimes charged when property transfers upon death. Both the federal government and some states charge estate taxes, but there are no federal inheritance taxes and only a limited number of states impose inheritance taxes.
Estate tax rules impose taxes depending on the size of the estate. A lot of money must typically change hands in order for any estate tax to be owed. For example, according to IRS estate tax law, you can pass on up to $12.06 million in assets in 2022 ($12.92 million in assets in 2023) without owing any federal estate tax. Only assets above this level are taxable. And you do not pay estate tax if your assets transfer to a surviving spouse.
Additionally, if the first spouse who dies does not use their $12.06 million in exemptions because they leave their money to their widow, the second spouse inherits that exemption and can pass $24.12 million in property without an estate tax.
When the transfer of wealth triggers an estate tax, the tax is paid out of the estate directly. People who inherit don't pay it — the money is taken from the assets the deceased left behind. Sometimes, if there's not enough cash in the estate, this could trigger the forced sale of some property.
Inheritance taxes are not based on the value of the estate but on the relationship of the person inheriting to the person who died. Close relatives, such as spouses, may not be taxed, depending on the state's rules.
Because estate tax and inheritance tax rates and rules differ depending where you live, it's important to know your own state's laws when figuring out how to manage your money in preparation for your death or after inheriting wealth.
States with inheritance tax
The states that charge inheritance taxes include:
- Iowa
- Kentucky
- Maryland
- Nebraska
- New Jersey
- Pennsylvania
States with estate tax
The states that charge an estate tax include:
- Connecticut
- Hawaii
- Illinois
- Maine
- Maryland
- Massachusetts
- Minnesota
- New York
- Oregon
- Rhode Island
- Vermont
- Washington, D.C.
- Washington
States with both
Only Maryland has both a state estate tax and a state inheritance tax.
8 ways to avoid inheritance tax
Based on what you just learned, if you believe you or your loved ones may be subject to inheritance tax, there are things you can do now to reduce that tax liability in the future.
1. Start giving gifts now
One way to reduce or avoid estate and inheritance taxes is to give gifts during your lifetime. If you give away your money and property while you are alive, your estate will be smaller and might not rise above the threshold at which taxes would be triggered.
You are allowed to give away up to $16,000 in 2022 ($17,000 in 2023) to any number of people you want over the course of a year without it being considered a taxable gift. This is $16,000 per recipient and per gifter. So if you have a spouse, you could collectively give away up to $32,000 in 2022 ($34,000 in 2023) to any number of recipients without having to report the gift and without any gift tax consequences.
This means if you and your spouse had three children, together you could give $32,000 per year to each child for a total of $96,000 in gifts each year without any tax implications.
If you exceed these $16,000 per person per recipient gift amounts, that still doesn't necessarily trigger taxes. It just counts against your lifetime gift and estate tax exemption. This exemption is $12.06 million per person in 2022 ($12.92 in 2023), and it applies to both gift tax and estate taxes.
If you use some of this $12.06 million exemption during your lifetime because you give gifts of more than $16,000 in a year, that reduces the exemption that applies to your estate when you die.
The $12.06 million threshold is in place only until 2025, after that, it reverts back to a $5.49 million exemption (adjusted for inflation) unless Congress takes action. If you think your estate will exceed this, you might want to give as much away now as you possibly can before the exemption is reduced. If you give away $12.06 million to your kids now, you'll get to claim the exemption and it won't matter if it is reduced later.
2. Write a will
If you write a will, the will needs to be probated unless you arrange for the transfer of assets using means that avoid probate. This means that unless your estate is a small one, a court process will be necessary to facilitate the transfer of wealth.
Usually, simply writing a will doesn't allow you to skip the probate process. You'd need to take other steps, such as creating a trust or titling any real estate as joint tenants with rights of survivorship in order for the property to pass outside probate.
When your estate is probated, the value of your assets is determined and the court decides who inherits based on your instructions. The value of the transferred wealth determines how much estate tax is owed, and the relationship to those who inherit determines how much inheritance tax is owed. There are not a lot of techniques you can implement simply by writing a will that reduces these taxes.
However, you can use a will to specify who inherits. And if you instruct that all your money goes to your spouse, this would allow you to avoid inheritance tax and estate tax because spouses aren't subject to either when they inherit a deceased partner's money or assets.
3. Use the alternate valuation date
The value of your estate determines how much estate tax you'll owe, but that value can change over time. Under the Tax Cuts and Jobs Act, you are allowed to use an alternate valuation date. That means you could opt to pay taxes on the value of the estate as determined six months subsequent to the date of death, rather than the value on the date of death itself.
If you want to use the alternate valuation date, you must calculate the entire value of the estate as of that date — you can't be selective and use different dates for different assets.
The only exception is if assets were sold between the date of death and the alternative valuation date, in which case their value on the day of the sale applies. If assets declined simply because of the passage of time, their value also must be determined as of the date of death.
If you want to use an alternate valuation date, you must elect to do so within one year of the time the estate tax return has to be filed. Once you decide to use the alternate valuation date, you can't change your decision.
4. Put everything into a trust
If you want to avoid estate taxes, you could create an irrevocable trust and transfer the ownership of your property into the trust. You will no longer own the assets, and they won't be a part of your estate. The trust will become the owner of the assets.
When you die, the trust remains the owner of the assets. But the beneficiary, or the person whom the trust benefits, can change to your chosen heirs.
This doesn’t work with all types of trusts, only with irrevocable trusts. And you have to give up some control over the property because the trust is the official owner, and you can't revoke the transfer of property to the trust. But no trust assets transfer upon death, so no estate or inheritance taxes are charged.
5. Take out a life insurance policy
You can purchase a life insurance policy and the death benefit payout is usually tax-free. Your beneficiaries (the people you choose to receive the death benefit) can use these proceeds to pay inheritance or estate tax. This doesn't reduce or eliminate these taxes, but it makes them easier to pay because they won't have to be paid out of your estate or out of the assets of the person who inherits.
You could also set up an irrevocable life insurance trust. In this case, you would hold the policy within the trust, and the trustee would pay premiums from trust assets. Upon death, the trustee collects the life insurance proceeds and uses them to pay for funeral expenses and to distribute the money to the beneficiaries of the trust.
This keeps the life insurance policy out of the estate so the value of the policy doesn't count toward determining whether the estate is taxable.
If you’re interested in using life insurance for tax purposes, then be sure to investigate the best life insurance companies before you decide on a policy.
6. Set up a family limited partnership
You can create a family limited partnership and transfer ownership of assets to that limited partnership. The family limited partnership will become a separate entity from you and your heirs. And you can give a gift of a partnership interest to your family members. The value of the gift is discounted under tax rules.
Say, for example, you create a family limited partnership and transfer $1 million of assets to it. And you give your children a 20% ownership interest. Because your children don't have control over the assets, the gift of the ownership interest isn't worth $200,000 but rather is considered to be worth much less.
7. Move to a state that doesn't have an estate or inheritance tax
Because only a minority of states impose inheritance taxes, relocating as a retiree could potentially help you save.
Just be sure you understand what state's rules will apply. When it comes to inheritance tax, the state where the deceased person lives matters — not the state where the person who inherits lives. So if you live in Pennsylvania, which charges inheritance taxes, and you leave money to your kids who live in Florida, which doesn't, your kids will still face inheritance taxes.
As for estate taxes, the location of the property determines which rules apply.
8. Donate to charity
Finally, you can donate money to charity to avoid estate taxes. There is an unlimited tax deduction for leaving money to charities, so any assets you leave to a qualifying organization won't be part of your taxable estate.
Start planning now to reduce your tax burden
Paying estate or inheritance taxes can be expensive and complicated (though the best tax software can make it easier). If you want to spare your loved ones the loss of assets or the aggravation that results from a huge inheritance tax bill, it's best to take steps as soon as possible to reduce that burden.
This can include:
- Make estate planning a priority. It is never too early to make a will, create an overall estate plan, or start gifting assets.
- Talk with a financial advisor or estate-planning attorney. A lawyer or financial professional can provide you with advice on how to reduce your tax bill.
- Choose your retirement location strategically. Retirement is often a good time to relocate to a state that has more favorable rules on the taxation of inheritances.
Bottom line
By planning in advance, you can reduce or even eliminate estate or inheritance taxes. It's worth making the effort so your loved ones can inherit your hard-earned money or property without having to give a cut to the federal or state government.
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FAQs
Place assets within a trust.
Another commonly used inheritance tax loophole is placing your assets within a trust. Your estate will not include these assets and therefore they avoid inheritance tax. Trusts are a great way to leave behind part of your estate to somebody who is too young to handle their affairs.
Is there a loophole around inheritance tax? ›
Place assets within a trust.
Another commonly used inheritance tax loophole is placing your assets within a trust. Your estate will not include these assets and therefore they avoid inheritance tax. Trusts are a great way to leave behind part of your estate to somebody who is too young to handle their affairs.
How do rich families avoid inheritance tax? ›
There are two major ways to avoid inheritance taxes: Move to a state that doesn't require inheritance taxes. Work with the owner of the estate before their passing to avoid potential taxes.
What is the best trust to avoid estate tax? ›
A Living Trust can help avoid or reduce estate taxes, gift taxes and income taxes, too.
What reduces federal estate tax? ›
These deductions may include mortgages and other debts, estate administration expenses, property that passes to surviving spouses and qualified charities. The value of some operating business interests or farms may be reduced for estates that qualify.
How do I get around not paying inheritance tax? ›
Cash, investments or property held in a trust sit outside of your estate for inheritance tax purposes, and can therefore help you avoid an inheritance tax bill. You may want to set up a trust for your children, grandchildren, or other family members.
How do I protect my inheritance from the IRS? ›
Here are 4 ways to protect your inheritance from taxes:
- See if the alternate valuation date will help. For tax purposes, the estates are evaluated based on their fair market value at the time of the decedent's death. ...
- Transfer your assets into a trust. ...
- Minimize IRA distributions. ...
- Make charitable gifts.
The states with no state estate tax as of mid-2023, are Alabama, Alaska, Arizona, Arkansas, California, Colorado, Delaware, Florida, Georgia, Idaho, Indiana, Kansas, Louisiana, Michigan, Mississippi, Missouri, Montana, Nevada, New Hampshire, New Mexico, North Carolina, North Dakota, Ohio, Oklahoma, South Carolina, ...
Do most millionaires inherited their money? ›
Dave Ramsey, personal finance expert and founder of Ramsey Solutions, says this myth of primarily inherited riches is “flat wrong.” When Ramsey's National Study of Millionaires asked where the riches came from, they found that a whopping 79% didn't receive any inheritance from parents or other family members.
What is considered a rich inheritance? ›
That said, an inheritance of $100,000 or more is generally considered large.
While trusts are highly structured, they do not protect your assets from creditors seeking restitution. In fact, creditors can file a claim against the beneficiaries of the estate should they learn of the person's passing.
What are the tax disadvantages of a living trust? ›
Lack of Tax Advantages
Despite popular opinion, living trusts do not provide any particular tax advantages. This is because the settlor can revoke the trust at any time and maintains control over the assets. Any income that is earned from trust assets is reported on the settlor's individual income tax return.
What type of trust has the best tax benefits? ›
Credit Shelter Trusts
The biggest benefit to a credit shelter trust is that as money grows, it's never subject to estate tax. A credit-shelter trust offers a way for you to pass on your estate and lower estate taxes.
Do beneficiaries pay taxes on inherited money? ›
Generally, beneficiaries do not pay income tax on money or property that they inherit, but there are exceptions for retirement accounts, life insurance proceeds, and savings bond interest. Money inherited from a 401(k), 403(b), or IRA is taxable if that money was tax deductible when it was contributed.
How much can you inherit without paying federal taxes? ›
According to the Internal Revenue Service (IRS), federal estate tax returns are only required for estates with values exceeding $12.06 million in 2022 (rising to $12.92 million in 2023). If the estate passes to the spouse of the deceased person, no estate tax is assessed.318 Taxes for 2022 are paid in 2023.
What is the major argument against an estate tax? ›
(1) One of the main arguments against an inheritance tax is that it, and the estate tax, essentially serves as double taxation on a deceased person's wealth.
What assets are free from capital gains tax? ›
Common examples of exempt assets are discussed below.
- Only or main residence. An individual's only or main residence is usually exempt from capital gains tax, although the situation is more complicated when the individual owns more than one property. ...
- Cars. ...
- Chattels.
Trust funds are legal arrangements that allow individuals to place assets in a special account to benefit another person or entity. Trust funds can be complex and often require the assistance of an attorney to set up, though there are online tools for the do-it-yourselfer.
What is the best way to protect your inheritance? ›
Put everything into a trust
If you are expecting an inheritance from parents or other family members, suggest they set up a trust to deal with their assets. A trust allows you to pass assets to beneficiaries after your death without having to go through probate.
Is it better to gift or inherit money? ›
From this perspective, you should gift as much as you can comfortably afford during your lifetime, while remaining aware of the capital-gain-basis step-up available for inherited assets. So, gift your assets that have minimal gains and save your most appreciated assets for inheritance.
The IRS finds out if you gave a gift when you file a form 709 as is required if you gift over the annual exclusion. If you fail to file this form, the IRS can find out via an audit.
Which US state has the best inheritance tax? ›
Massachusetts and Oregon have the lowest exemption levels at $1 million, and Connecticut has the highest exemption level at $9.1 million. Of the six states with inheritance taxes, Nebraska has the highest top rate at 18 percent.
What state has the highest inheritance tax? ›
State estate taxes: Top tax rates and exemption thresholds, tax year 2022
- Connecticut: 12%, $9,100,000.
- District of Columbia: 16%, $4,000,000.
- Hawaii: 20%, $5,490,000.
- Illinois: 16%, $4,254,800.
- Maine: 12%, $6,010,000.
- Maryland: 16%, $5,000,000.
- Massachusetts: 16%, $1,000,000.
- Minnesota: 16%, $3,000,000.
What states have inheritance taxes? The six states that impose an inheritance tax are Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania.
What age do most people inherit money? ›
We find that inheritance size is highly correlated with income, particularly at the top end of the income distribution; the bulk of inheritances are received between the ages of 46 and 75; and that most inheritances come from parents.
Did 79 millionaires inherit $0? ›
The overwhelming majority (79%) of millionaires in the U.S. did not receive any inheritance at all from their parents or other family members. While 1 in 5 millionaires (21%) received some inheritance, only 3% received an inheritance of $1 million or more.
What family has the most generational wealth? ›
The Walton family is the world's richest family, with an estimated net worth of $247 billion. The majority of the family's wealth comes from their ownership of Walmart, the largest retailer in the world, founded in 1962 by Sam Walton.
How much money does the average American inherit? ›
The Federal Reserve's 2019 Survey of Consumer Finances (SCF) found that the average inheritance in the U.S. is $110,050.
Does inheritance affect Social Security? ›
Income from working at a job or other source could affect Social Security and SSDI benefits. However, receiving an inheritance won't affect Social Security and SSDI benefits.
What is the average American net worth at death? ›
The Survey of Consumer Finances (SCF), reports that the median inheritance was $69,000 (the average was $707,291).
What assets cannot be placed in a trust?
- Retirement assets. While you can transfer ownership of your retirement accounts into your trust, estate planning experts usually don't recommend it. ...
- Health savings accounts (HSAs) ...
- Assets held in other countries. ...
- Vehicles. ...
- Cash.
Suze Orman provides a lot of financial advice on a broad range of topics, but she's known for arguing that revocable living trusts in particular are some of the most valuable tools a person might use in the estate planning process.
Should a 401K go into a trust? ›
Retirement accounts like an IRA, Roth IRA, 401K, 403b, 457 and the like don't belong in your trust. Placing any of these assets in your trust would mean that you're taking them out of your name to retitle them in the name of your trust. The impact this will have on your taxes can be disastrous.
Why do rich people put their homes in a trust? ›
To reduce income taxes and to shelter assets from estate and transfer taxes. To provide a vehicle for charitable giving. To avoid court-mandated probate and preserve privacy. To protect assets held in trust from beneficiaries' creditors.
What is the advantage of a trust versus a will? ›
The primary advantage of setting up a trust is to avoid delays in distributing your assets to your children or other family members after you die. A will must go through the probate process in court, which takes time and can be costly.
What are the IRS rules for a living trust? ›
Living trusts have to file tax returns in most cases if they have $600 or more in income for a given tax year. They may also have to file if the living trust is a grantor-controlled trust or a revocable marital trust and both spouses are still living. Trusts that file tax returns do so using Form 1041.
What is the best trust to protect your assets? ›
Irrevocable trust
Most trusts can be irrevocable. An irrevocable trust offers your assets the most protection from creditors and lawsuits. Assets in an irrevocable trust aren't considered personal property. This means they're not included when the IRS values your estate to determine if taxes are owed.
Who is the best person to set up a trust? ›
A good Trustee should be someone who is honest and trustworthy, because they will have a lot of power under your trust document. The person you choose to act as a Trustee should also be financially responsible, because they will be handling the investments for the benefit of your beneficiaries.
What are the best states to file a trust? ›
That really depends on which benefits are most important to you. But, generally, the consensus among advisers and estate attorneys is that the trust laws of South Dakota and Nevada offer the best combination of tax benefits, asset protection, trust longevity and flexible decanting provisions. Why Do I Need a Trust?
Do I need to report inheritance money to IRS? ›
Is inheritance taxable income? Regarding your question, “Is inheritance taxable income?” Generally, no, you usually don't include your inheritance in your taxable income. However, if the inheritance is considered income in respect of a decedent, you'll be subject to some taxes.
Lifetime Gifting Limits
Each individual has a $11.7 million lifetime exemption ($23.4M combined for married couples) before anyone would owe federal tax on a gift or inheritance. In other words, you could gift your son or daughter $10 million dollars today, and no one would owe any federal gift tax on that amount.
What happens when you inherit money from a trust? ›
The trust itself must report income to the IRS and pay capital gains taxes on earnings. It must distribute income earned on trust assets to beneficiaries annually. If you receive assets from a simple trust, it is considered taxable income and you must report it as such and pay the appropriate taxes.
Is there a workaround to inheritance tax? ›
Give your assets away
If you give assets away and you survive for at least 7 years then all gifts are free and avoid inheritance tax. If you die within 7 years then inheritance tax will be paid on a reducing scale.
How do I deposit a large cash inheritance? ›
A good place to deposit a large cash inheritance, at least for the short term, would be a federally insured bank or credit union. Your money won't earn much in the way of interest, but as long as you stay under the legal limits, it will be safe until you decide what to do with it.
What are the downsides of inheritance tax? ›
Drawbacks. Estate tax critics refer to it as a death tax. They argue that it penalizes a person for being successful. One of the biggest shortcomings of the estate tax is that it forces individuals to pay taxes on the same assets twice – once when they are bought and once when they are passed on to settlors' heirs.
What are two methods of avoiding the estate tax? ›
How to Avoid the Estate Tax
- Give Gifts to Family. One way to get around the estate tax is to hand off portions of your wealth to your family members through gifts. ...
- Set Up an Irrevocable Life Insurance Trust. ...
- Make Charitable Donations. ...
- Establish a Family Limited Partnership. ...
- Fund a Qualified Personal Residence Trust.
Here are five ways to avoid paying capital gains tax on inherited property.
- Sell the inherited property quickly. ...
- Make the inherited property your primary residence. ...
- Rent the inherited property. ...
- Disclaim the inherited property. ...
- Deduct selling expenses from capital gains.
(IV) Arguments Against Inheritance Tax
(1) One of the main arguments against an inheritance tax is that it, and the estate tax, essentially serves as double taxation on a deceased person's wealth. (2) An inheritance tax disproportionately burdens small businesses.
What states are exempt from inheritance tax? ›
The states with no state estate tax as of mid-2023, are Alabama, Alaska, Arizona, Arkansas, California, Colorado, Delaware, Florida, Georgia, Idaho, Indiana, Kansas, Louisiana, Michigan, Mississippi, Missouri, Montana, Nevada, New Hampshire, New Mexico, North Carolina, North Dakota, Ohio, Oklahoma, South Carolina, ...
Do I have to pay inheritance tax on life insurance? ›
Answer: Generally, life insurance proceeds you receive as a beneficiary due to the death of the insured person, aren't includable in gross income and you don't have to report them. However, any interest you receive is taxable and you should report it as interest received.
If you receive a gift, you do not need to report it on your taxes. According to the IRS, a gift occurs when you give property (like money) without expecting anything in return. If you gift someone more than the annual gift tax exclusion amount ($16,000 in 2022), the giver must file Form 709 (a gift tax return).
What is considered a large inheritance? ›
In general, a large inheritance is considered to be a sum of money or assets that is significantly larger than the individual's typical annual income. Specifically, for some individuals, a large inheritance may be considered to be $100,000 or more, while for others, it may be several million dollars.
What is the progressive inheritance tax? ›
A type of wealth transfer tax in which the recipient, rather than the donor's estate, is taxed. An inheritance tax applies to the gifts and bequests a taxpayer receives. Unlike estate and gift taxes, a progressive inheritance tax gives donors an incentive to spread their wealth more broadly.
Which state has the highest inheritance tax? ›
State estate taxes: Top tax rates and exemption thresholds, tax year 2022
- Connecticut: 12%, $9,100,000.
- District of Columbia: 16%, $4,000,000.
- Hawaii: 20%, $5,490,000.
- Illinois: 16%, $4,254,800.
- Maine: 12%, $6,010,000.
- Maryland: 16%, $5,000,000.
- Massachusetts: 16%, $1,000,000.
- Minnesota: 16%, $3,000,000.
States With No Estate or Inheritance Taxes
- Alabama.
- Alaska.
- Arizona.
- Arkansas.
- California.
- Colorado.
- Delaware.
- Florida.
There is no federal inheritance tax and only six states levy the tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
What is the Goodman rule? ›
In the Goodman case, as long as Mrs. Goodman obtained some control over her husband's life insurance policies, the death benefit was considered an “incomplete gift”. In the event of the insured party's death, the gift is completed and the contract terms cannot be changed.
Is life insurance considered part of an estate? ›
Generally, death benefits from life insurance are included in the estate of the owner of the policy, regardless of who is paying the insurance premium or who is named beneficiary.
How to use life insurance to avoid estate taxes? ›
Using an Ownership Transfer to Avoid Taxation
If you want your life insurance proceeds to avoid federal taxation, you'll need to transfer ownership of your policy to another person or entity.
How does the IRS know if I give a gift? ›
The IRS finds out if you gave a gift when you file a form 709 as is required if you gift over the annual exclusion. If you fail to file this form, the IRS can find out via an audit.
The gift tax limit for 2022 was $16,000. This amount, formally called the gift tax exclusion, is the maximum amount you can give a single person without reporting it to the IRS.
