How To Pass Money to Heirs Tax-Free: 8 Smart Strategies

9 MIN READ

Estate planning helps you make sure that your hard-earned assets reach your loved ones with minimal tax burden. Many people assume the government will take a large portion of their estate, but there are legitimate strategies to minimize or eliminate these taxes.

Here's how to pass money to heirs tax-free so that you can transfer wealth most efficiently and set your legacy up for success. We'll go over strategies like annual gift tax exclusion, forming an irrevocable grantor trust, Roth IRA conversions, and more.

Do Beneficiaries Get Taxed on Inheritance?

When someone inherits money or property, taxes can come into play in different ways:

Federal Estate Tax: This is a tax on the total value of what you own when you die. The estate pays this tax before anything goes to your heirs. Most people never pay this tax because it only applies to large estates - over $13,990,000 in 2025.
State Inheritance and Estate Taxes: While the federal government taxes the estate as a whole, some states tax the people who receive the inheritance directly. Only five states currently have inheritance taxes: Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Iowa phased out its inheritance tax in 2025. Twelve states and Washington D.C. have their own estate taxes, which often kick in at lower amounts than the federal tax.
Income Tax on Inherited Assets: Most inherited money or property isn't subject to income tax, but if what you inherit later produces income (like interest from a savings account or rent from a property), you'll pay taxes on that new income.
Capital Gains Tax: When you inherit assets that have increased in value (like stocks or real estate), you get a tax advantage called a "step-up in basis." This means the asset's value is reset to its worth on the date of death. If you sell the asset right away, you'll pay little or no capital gains tax. If you hold it and it continues to grow in value, you'll only pay tax on the growth that happens after you inherited it.

According to the Federal Reserve, the average American inheritance is $46,200. This number is misleading, though, because super-wealthy families pull the average up. Most people inherit less than this amount.

How Much Can You Pass to Heirs Tax-Free?

In 2025, you can leave up to $13,990,000 to your heirs without paying federal estate tax. Married couples can double this amount.

States with their own inheritance or estate taxes typically allow less tax-free money than the federal government, so make sure to check your state's rules.

The federal estate tax exemption changes every year to adjust to inflation.

Related Article | Raising Children with Good Money Habits

How to Pass Money to Heirs Tax-Free: 8 Strategies You Can Use

1. Annual Gifting

The simplest way to reduce your taxable estate is by giving money each year while you're alive.

The IRS allows you to give up to $19,000 (in 2025) to as many people as you want each year without filing a gift tax return. A married couple can give $38,000 per recipient annually.

These gifts don't count against your lifetime gift tax exemption.

This strategy works well if you start early. For example, a couple with three children and six grandchildren could give away $342,000 annually ($38,000 × 9 recipients) without any tax impact. Over ten years, that's over $3.4 million removed from your taxable estate.

2. Irrevocable Grantor Trust

An irrevocable trust removes assets from your estate for tax purposes. Once you transfer assets into this trust, you legally give up ownership and control over them. The trust terms can't be easily changed or revoked, which is why it effectively removes assets from your taxable estate.

The "grantor" part means you still pay income taxes on the trust's earnings, even though you don't own the assets anymore.

When you pay the taxes yourself, you're essentially making additional tax-free gifts to your heirs. The assets in the trust typically continue to appreciate, too. Popular versions include Grantor Retained Annuity Trusts (GRATs) and Intentionally Defective Grantor Trusts (IDGTs).

3. Downsides to Consider

You typically permanently lose control and access to the assets
The trust terms are often difficult or impossible to change if your family circumstances change
Setting up and maintaining these trusts will typically require an estate planning attorney

4. Life Insurance Policy

Life insurance provides a death benefit that's generally income-tax-free to beneficiaries. When structured properly, it can also avoid estate taxes.

One solid strategy for estate tax purposes is having an Irrevocable Life Insurance Trust (ILIT) own the policy rather than owning it yourself.

You make gifts to the trust to cover premium payments, and when you die, the insurance proceeds go to your beneficiaries outside of your taxable estate.

5. Family Limited Partnership (FLP)

A Family Limited Partnership works like a small family business that holds and manages assets. You (and possibly your spouse) serve as general partners who control the partnership, while your children or grandchildren are limited partners with ownership rights but no control.

With an FLP, you can gift partnership interests to family members. These gifts often qualify for "discounts" because limited partners can't sell their shares easily or make decisions about the assets.

For this to work legally, the FLP must have a real business purpose beyond just avoiding taxes. It needs to actively manage investments or operate a business and follow all partnership formalities. Make sure to consult with a wealth planning professional and adhere to all the necessary tax laws.

6. Direct Payments

This is another simple, tax-free strategy that doesn't count against your gift lifetime exemption.

The Internal Revenue Service (IRS) allows you to pay unlimited amounts for someone else's medical bills or tuition without triggering a gift tax - as long as you pay the provider directly.

For example, you could pay $50,000 directly to your grandchild's college for tuition, plus give them your annual gift allowance of $19,000, all with no tax liability. This strategy works for educational expenses at any level, from preschool through graduate school.

For medical expenses, you can pay for treatments, hospital stays, lab work, and even health insurance premiums. These payments must go straight to the medical provider, not to the person receiving care.

7. Generation-Skipping Trust

A generation-skipping trust moves assets directly to beneficiaries who are at least two generations below you (typically grandchildren or great-grandchildren). The IRS defines "skip persons" as anyone who is at least 37½ years younger than you.

This strategy helps avoid multiple layers of estate tax. Without it, your assets would be taxed when you leave them to your children and again when your children leave them to their children.

This works particularly well in families where the middle generation already has substantial resources.

That said, the IRS imposes a separate generation-skipping transfer tax (GSTT) specifically to address these arrangements - the current rate is 40%. However, you get a lifetime GSTT exemption, which is $13,990,000 in 2025 (it typically matches the lifetime gift tax exemption amount).

8. Roth IRA Conversions

Converting traditional retirement accounts to Roth IRAs creates a tax-free inheritance for your heirs. You'll pay income tax on the conversion now, but all future growth becomes tax-free.

When your heirs inherit a Roth IRA, they won't pay income tax on withdrawals (unlike with traditional IRAs).

This strategy works best when you expect your investments to grow significantly or believe tax rates will be higher in the future when your heirs would be taking distributions.

So, What Is the Best Way to Pass Money to Heirs?

There's no single "best" strategy for everyone. It's typically a good idea to start with the simplest methods first: annual gifting and direct payments for education and medical expenses.

For larger estates, you can combine these basic strategies with more advanced options like irrevocable trusts or family partnerships. Make sure to work with an experienced estate planning attorney or tax professional to make the most of your wealth transfer.

FAQs

Is It Better to Gift Money or Leave It as an Inheritance?

It ultimately depends on your situation, but gifting money during your lifetime has a few important advantages. You can use the annual gift tax exclusion ($19,000 in 2025) to reduce your taxable estate without using your lifetime exemption. Giving while you're alive also allows you to see your loved ones benefit from your generosity and potentially help them when they need it most, such as for education or buying a home. But inheritance can work well, too - assets typically receive a step-up in basis at death, which can reduce capital gains taxes for appreciated assets like real estate or stocks.

Is It Better to Give Kids an Inheritance While Alive?

Giving money to your children while you're alive means you'll likely be providing financial support when they might need it most - during early adulthood when they're establishing careers, buying homes, or raising families. It also allows you to educate them on managing their money and financial responsibility. You can take advantage of strategies like annual gifting and direct payments. If you have a large estate, you can still use these basic strategies, but you will also likely need to do some advanced planning to reduce the tax bill, such as setting up an Intentionally Defective Grantor Trust.

What Are the IRS Rules for Gifting Money to Family Members?

For 2025, you can give up to $19,000 per person annually without filing a gift tax return or using any of your lifetime gift tax exemption. Married couples can combine their annual exclusions to give $38,000 per recipient. Gifts exceeding this amount require filing a gift tax return and count against your lifetime exemption ($13.99 million in 2025), though actual gift tax is only due once you exceed that lifetime limit.

The Bottom Line

It's not easy to figure out how to pass money to heirs tax-free, especially if you have a large estate, but specialized trusts and advanced techniques can help you reduce or even eliminate estate and gift taxes.

While it may not be possible to pass money to your heirs completely tax-free, you can minimize taxes significantly when you work with a qualified tax adviser and an estate planning attorney.