How To Avoid Inheritance Tax with a Trust: Simple Guide

11 MIN READ

When passing down wealth to your loved ones, you naturally want them to receive as much as possible without losing a significant portion to taxes. For families with substantial estates, inheritance taxes can take a big bite out of what you leave behind.

So, you may be wondering how to avoid inheritance tax with a trust. While it may not be possible to completely eliminate taxes using a trust, it's possible to reduce your tax burden - sometimes, by a lot.

Many facilities with larger estates use trusts to protect their assets from excessive taxation and help more of their wealth reach their heirs. Here's everything you need to know.

How Much Inheritance Is Tax-Free?

In 2025, each person can leave up to $13.99 million to heirs without triggering federal estate or gift tax. This is known as the lifetime estate tax exemption. For married couples, this means you can potentially pass on nearly $28 million tax-free by combining both spouses' exemptions.

This exemption covers all the assets in your estate, such as your home, investments, retirement accounts, business interests, and personal property. Any amount above this threshold gets taxed at the federal estate tax rate, which can be as high as 40%.

Some states have their own inheritance or estate taxes with much lower exemption amounts, sometimes starting at just $1 million. This means you might avoid the federal estate tax but still face state-level taxes.

Let's dig into the different types of taxes you might have to pay on an inheritance.

Relevant Article | Estate and Inheritance Taxes Are More Complicated for Immigrants

The Main Types of Taxes on Inheritances

When money and assets pass from one person to another after death, several different taxes might apply.

Estate Tax

Estate tax is paid by the estate itself, not by the people who inherit it. The government looks at everything you owned when you died, such as your house, investments, and retirement accounts.

They add up the total value, subtract your debts and funeral expenses, and then apply the estate tax to anything above the exemption amount.

Only estates worth more than $13.99 million (for 2025) face the federal estate tax. If your estate exceeds this amount, the tax rate starts at 18% and can go up to 40% on the excess value.

The executor of your estate handles filing the estate tax return and paying any tax due before assets are distributed to heirs.

Related Article | How to Pass Money to Heirs Tax-Free

Inheritance Tax

The inheritance tax is paid by the people who receive the assets, not by the estate. The federal government doesn't impose an inheritance tax, but some states do.

As of 2025, only five states have an inheritance tax: Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Iowa used to have an inheritance tax, but it phased it out for deaths on or after January 1, 2025.

The tax rates and exemptions vary by state and often depend on your relationship to the deceased. Spouses are typically exempt, and children often face lower rates than distant relatives or non-relatives.

Income Tax

Most of the time, you don't have to pay income taxes on an inheritance. However, there are some situations where it may be applicable, including the following:

Retirement accounts like traditional IRAs and 401(k)s. When heirs withdraw money from these accounts, they pay income tax on the distributions.
Annuities often have taxable components.
Savings bonds that the original owner never paid tax on.

Cash, stocks, real estate, and life insurance proceeds generally pass to heirs income-tax free.

Capital Gains Tax

Capital gains tax becomes relevant when heirs sell inherited assets that have increased in value. However, it's important to know that inherited assets receive what's called a "step-up in basis."

This means the asset's tax basis becomes its fair market value on the date of death, not what the original owner paid for it. As a result, tax implications can be much lower.

Let's say your father purchased shares in a company for $5,000 decades ago. By the time he passes away, those shares are worth $80,000. Your new tax basis is $80,000, not his original $5,000. If you later sell those shares for $95,000, you only pay capital gains tax on $15,000 (the growth that occurred after you inherited them) rather than the full $90,000 increase from the original purchase price.

In other words, the main types of taxes that you typically have to watch out for when passing your wealth down to your heirs are estate and inheritance taxes.

There are ways to minimize or even avoid estate taxes, and one of them is using a trust.

What Types of Trusts Are Tax Exempt?

No trust is completely tax-exempt in all situations. However, certain trusts can help reduce or delay different types of taxes, depending on how they're set up. It's often highly recommended to work with a qualified estate planning attorney.

Irrevocable trusts often provide the most tax benefits because you permanently transfer assets out of your estate. Revocable trusts, while useful for avoiding probate, don't typically provide estate tax benefits because you maintain control of the assets during your lifetime.

Different Types of Trusts You Can Use to Reduce Estate Tax Liability

Revocable Living Trust

A revocable living trust is like a container that holds your assets while you're alive. You maintain complete control. You can add or remove assets, change beneficiaries, or even cancel the entire trust.

It avoids probate, keeping your affairs private and typically reducing settlement time and costs. It also allows for seamless management of your assets if you become incapacitated. You can include detailed instructions for distributing assets to beneficiaries.

However, it doesn't reduce estate or inheritance taxes because you maintain control of the assets.

Assets in a revocable trust are still considered part of your taxable estate, and income generated by trust assets is reported on your personal tax return.

That said, this type of trust can still work well for people who are primarily concerned with avoiding probate and maintaining control of their assets during their lifetime. Just keep in mind that it doesn't do much for both an estate tax and an inheritance tax.

Irrevocable Life Insurance Trusts (ILITs)

An ILIT owns a life insurance policy on your life. When you set it up, you transfer ownership of your policy to the trust, or the trust purchases a new policy. The trust owns the policy, and you make cash gifts to the trust to cover premium payments.

Upon your death, the insurance proceeds go into the trust, and the trustee distributes the proceeds according to your instructions.

The tax benefits include removing life insurance proceeds from your taxable estate, providing liquidity to pay estate taxes without forcing heirs to sell other assets, and policy proceeds aren't subject to income tax when beneficiaries receive them.

Keep in mind that you must live at least three years after transferring an existing policy to an ILIT for it to be excluded from your estate.

Related Article | At What Net Worth Do I Need a Trust?

Grantor Retained Annuity Trusts (GRATs)

With a GRAT, you can pass growing assets to your heirs with little to no gift tax cost.

You place assets into the trust for a specific term (typically 2-10 years). During this term, you receive annual payments from the trust. When the term ends, any remaining assets pass to your beneficiaries.

For estate tax purposes, the advantages include transferring future appreciation to heirs with minimal gift tax. This works especially well with rapidly appreciating assets or when interest rates are low and can be structured as a "zeroed-out GRAT," where the gift tax value is effectively zero.

Charitable Remainder Trusts (CRTs)

A CRT combines charitable giving with benefits for you and your heirs.

You transfer assets to the trust, and you or your beneficiaries receive income for a specified period (up to 20 years) or for life. After this period ends, the remaining assets go to your chosen charity.

The tax benefits include an immediate income tax deduction for a portion of the assets transferred, no capital gains tax when the trust sells appreciated assets, a reduction in the size of your taxable estate, and a potential income stream for you or your beneficiaries.

Intentionally Defective Grantor Trust (IDGT)

Despite its strange name, there's nothing truly "defective" about an IDGT, and it can be a good asset to your financial goals. Its name refers to the fact that it creates a tax disconnect. It's outside your estate for estate tax purposes but still yours for income tax purposes.

You sell assets to the trust in exchange for a promissory note. You pay income tax on the trust's earnings, allowing the trust to grow tax-free. The value of the assets is frozen at the time of the sale for estate tax purposes.

From a tax perspective, any value growth happens outside your estate and won't be subject to estate tax. When you pay the income taxes on the trust's earnings, you're essentially making tax-free gifts to your beneficiaries.

Plus, you receive interest payments on the promissory note, giving you an income stream.

Qualified Personal Residence Trusts (QPRTs)

A QPRT helps you pass your home to family members with less tax. You put your house in the trust but keep the right to live there for a set number of years. When that time ends, the house goes to your beneficiaries. If you want to continue living there, you can pay rent to them.

The gift's value for tax purposes is reduced because you're only giving away the future ownership, not the immediate use of the property.

The home's value gets locked in when you create the trust, so any increase in property value passes tax-free to your heirs. However, keep in mind that you must survive the trust term for these tax savings to work. If you die before the term ends, your home goes back into your taxable estate.

Dynasty Trusts

A dynasty trust is designed to last for multiple generations, potentially forever in states that allow perpetual trusts. You can fund it with assets up to your lifetime gift tax exemption amount.

The trust supports your children, grandchildren, and future descendants according to your instructions, with a professional trustee handling the investments and distributions.

Once assets enter the trust, they can grow and pass from generation to generation without being hit by the estate tax at each death. As a bonus, these trusts also shield assets from your beneficiaries' creditors and ex-spouses.

FAQs

Which Trust Is Best to Avoid Inheritance Tax?

For pure tax savings, irrevocable trusts generally work best because they remove assets from your taxable estate. The "best" trust depends on your specific situation and goals. If you own a life insurance policy, an ILIT might be ideal.

For a family home, consider a QPRT. For investment assets expected to grow substantially, a GRAT or IDGT could be your best option. There's no one-size-fits-all answer - the right trust depends on what you own, who you want to benefit, and how much control you're willing to give up.

Do Beneficiaries Pay Taxes on a Trust?

It depends on the type of trust and what's being distributed. Beneficiaries generally don't pay taxes on distributions of the original assets (principal) placed in the trust.

However, they typically do pay income tax on any interest, dividends, or other income generated by trust assets and distributed to them. The trust itself pays taxes on income it retains. For certain trusts like grantor trusts, the person who created the trust pays all the income taxes, even on income that benefits the beneficiaries (which is a tax advantage for the beneficiaries).

Does a Trust Avoid Capital Gains Tax?

Trusts don't automatically avoid capital gains tax, but they can provide advantages. Assets in most revocable trusts still receive a step-up in basis at your death, wiping out capital gains that occurred during your lifetime. For irrevocable trusts, it's more complex. Some don't qualify for the step-up in basis, meaning eventual capital gains taxes might be higher.

What Six States Have Inheritance Taxes?

In 2025, only FIVE states impose inheritance taxes: Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Iowa previously had an inheritance tax but phased it out as of January 1, 2025. The tax rates and exemptions vary significantly by state, with tax rates typically ranging from 1% to 18%.

The Bottom Line

Starting a trust can help you reduce inheritance taxes, but you'll need to do some careful planning, ideally with a financial advisor. There are also certain trade-offs to consider, such as losing control over your assets with many irrevocable trusts.

An estate planning professional can help you figure out how to reduce state and federal taxes while following all of the necessary tax rules.