The federal estate tax applies to fewer than 1% of estates each year. But for the estates it does reach, it can claim a significant portion of assets at rates up to 40%. Trusts are the primary planning tool used to manage estate tax exposure, and understanding how they interact with the tax rules determines whether that planning actually works.
What Is the Estate Tax and Who Pays It?
The federal estate tax is imposed on the transfer of property at death. It applies to the gross estate — essentially everything the decedent owned or had an interest in — after subtracting debts, funeral expenses, administrative costs, and certain deductions including the unlimited marital deduction for transfers to a surviving spouse.
The tax only applies if the taxable estate exceeds the federal exemption amount. For 2025, that exemption is $13.99 million per person. A married couple can effectively shelter nearly $28 million from federal estate tax using portability, which allows a surviving spouse to use any unused portion of the deceased spouse's exemption. Estates below the exemption owe no federal estate tax at all.
The exemption amount is not permanent. The current elevated exemption was established by the Tax Cuts and Jobs Act of 2017 and is scheduled to sunset at the end of 2025, reverting to approximately half the current level (adjusted for inflation) unless Congress acts. Estates that are not currently taxable could become taxable depending on what happens to the law. This uncertainty is one of the primary drivers of estate planning activity right now.
When the federal estate tax does apply, it is progressive, with a top rate of 40% on amounts above the exemption. The tax is paid by the estate before assets are distributed to beneficiaries, not by the beneficiaries themselves. A $20 million estate with no planning could owe roughly $2.4 million in federal estate tax on the $6 million above the current exemption.
Federal vs. State Estate and Inheritance Taxes
The federal exemption does not protect against state-level death taxes. Twelve states and the District of Columbia impose their own estate tax, several with exemptions far below the federal threshold. Massachusetts and Oregon tax estates above $1 million. Washington State's exemption is $2.193 million. Illinois exempts estates up to $4 million. New York has an exemption of $6.94 million but applies a "cliff" that eliminates the exemption entirely for estates more than 5% over the threshold.
Inheritance taxes are different from estate taxes. An estate tax is imposed on the estate before distribution. An inheritance tax is imposed on the beneficiary receiving assets. Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania impose inheritance taxes. The rate and exemptions vary by state and often by the relationship between the decedent and the beneficiary — spouses and children typically pay less or nothing, while more distant relatives and unrelated beneficiaries often pay more.
California, Texas, and Florida impose no state estate or inheritance tax. New York and Illinois have estate taxes with relatively low exemptions compared to the federal level. For residents of high-tax states, state-level planning is a separate and equally important consideration from federal planning.
How Trusts Interact With Estate Tax
The relationship between trusts and estate taxes depends almost entirely on whether the trust is revocable or irrevocable, and on specific provisions within the trust document.
A revocable living trust — the most common type of trust used in basic estate planning — provides no estate tax benefit whatsoever. Because the grantor retains the right to amend or revoke the trust, the IRS treats the trust assets as part of the grantor's taxable estate. The value of revocable trusts lies in avoiding probate and managing asset distribution, not in tax reduction.
Irrevocable trusts can remove assets from the taxable estate, but only when properly structured. When assets are transferred into an irrevocable trust and the grantor gives up control, ownership, and beneficial interest in those assets, they generally leave the taxable estate. The word "generally" is doing significant work in that sentence. Certain retained interests — the right to income, the right to change beneficiaries, or other controls — can cause the assets to be pulled back into the estate despite the irrevocable structure. Trust drafting matters enormously here.
Grantor trusts add a layer of complexity. A grantor trust is one where the IRS treats the grantor as the owner of the trust for income tax purposes even though the assets may be outside the estate for estate tax purposes. This can actually be advantageous: the grantor pays income tax on trust earnings, which effectively reduces the taxable estate further (since those tax payments leave the estate) while the trust assets grow tax-free inside the trust. Intentionally Defective Grantor Trusts (IDGTs) exploit this dynamic deliberately.
The Step-Up in Basis and Why It Matters
The step-up in basis is one of the most significant tax benefits available at death, and it interacts with trust planning in ways that are easy to overlook. When someone inherits an asset, its cost basis for capital gains purposes resets to the fair market value at the date of death. If the decedent paid $100,000 for stock now worth $500,000 at death, the heir's basis is $500,000. Selling immediately produces no capital gain.
This benefit is only available for assets included in the taxable estate. Assets held in an irrevocable trust that have been removed from the taxable estate do not receive a step-up in basis at the grantor's death. The beneficiary inherits the trust's original cost basis, not the date-of-death value. For highly appreciated assets, the capital gains tax exposure from losing the step-up can sometimes exceed the estate tax savings from removing the asset from the estate.
This is one of the central tensions in estate tax planning. Aggressive removal of assets from the estate to reduce estate tax can eliminate the step-up in basis for those assets, creating a different tax problem for beneficiaries. The right answer depends on the expected holding period, the degree of appreciation, the applicable capital gains rates, and the size of the estate relative to the exemption.
Trust Income Taxation
Trusts pay income tax as separate entities, and the rates are compressed significantly compared to individual rates. In 2025, a trust reaches the 37% federal income tax bracket at just $15,650 of taxable income. An individual does not reach that bracket until income exceeds $609,350. This compression makes accumulating income inside a trust tax-inefficient.
Most trusts are designed to distribute income to beneficiaries rather than accumulate it, because distributed income is taxed at the beneficiary's individual rate rather than the trust's compressed rate. Distributions of trust income are reported on a K-1 to the beneficiary, who includes them in their own return. The trust takes a deduction for distributions made, effectively passing the tax liability to the beneficiary.
Grantor trusts, as noted above, are an exception. All trust income is taxed directly to the grantor regardless of distributions, at the grantor's individual rate. This can be beneficial or not depending on the grantor's tax situation and planning goals.
Common Estate Tax Planning Strategies Using Trusts
Several trust structures are specifically designed to reduce estate tax exposure. Each involves trade-offs worth understanding before implementation.
A Spousal Lifetime Access Trust (SLAT) allows one spouse to transfer assets to an irrevocable trust for the benefit of the other spouse, removing the assets from the first spouse's estate while maintaining indirect access through the beneficiary spouse. The risk is that divorce or the death of the beneficiary spouse eliminates that access entirely.
A Grantor Retained Annuity Trust (GRAT) allows the grantor to transfer assets to an irrevocable trust, retain an annuity payment for a fixed term, and pass any appreciation above the IRS hurdle rate to beneficiaries estate-tax-free at the end of the term. GRATs work best when interest rates are low and the transferred assets are expected to appreciate significantly. If the grantor dies during the trust term, the strategy fails and the assets return to the estate.
Charitable Remainder Trusts (CRTs) and Charitable Lead Trusts (CLTs) combine estate planning with charitable giving. A CRT provides income to the grantor or other beneficiaries for a period, with the remainder passing to charity. A CLT provides income to charity for a period, with the remainder passing to heirs at a reduced taxable value. Both produce charitable deductions that reduce the taxable estate.
Irrevocable Life Insurance Trusts (ILITs) hold life insurance policies outside the taxable estate. Life insurance proceeds are generally includible in the taxable estate if the decedent held any incidents of ownership in the policy. An ILIT removes that ownership, keeping the proceeds out of the estate while making them available to beneficiaries or to provide liquidity for estate tax payments.
A Common Scenario
A couple in their late 60s has a combined estate of $18 million, primarily in appreciated real estate and a taxable investment portfolio. Their estate is currently below the combined federal exemption using portability, but the scheduled 2026 exemption reduction would leave approximately $4 million exposed to federal estate tax, plus Illinois estate tax on amounts above $4 million. Their attorney recommends transferring $5 million of the investment portfolio into a SLAT before year-end to lock in the current exemption amount. The trade-off is that the transferred assets lose their step-up in basis at the first spouse's death, creating potential capital gains exposure for the beneficiary spouse if she sells. Whether the estate tax savings outweigh the lost step-up depends on projections of appreciation and expected holding periods — a calculation worth running before acting.
Frequently Asked Questions
Does a revocable living trust reduce estate taxes?
No. A revocable living trust provides no estate tax benefit because the grantor retains control over the assets. The IRS includes revocable trust assets in the grantor's taxable estate. The value of a revocable trust lies in avoiding probate, managing incapacity, and controlling asset distribution — not in reducing estate taxes. If estate tax reduction is a goal, irrevocable trust structures are required.
What happens to the estate tax exemption after 2025?
The elevated exemption established by the Tax Cuts and Jobs Act of 2017 is scheduled to sunset on December 31, 2025, reverting to approximately $7 million per person (adjusted for inflation) unless Congress extends it. Whether and how Congress will act is uncertain as of early 2026. Estates that would be taxable under the lower exemption but are not currently taxable under the elevated one have an incentive to act before any reduction takes effect.
Do assets in an irrevocable trust get a step-up in basis at death?
Generally no, if the assets have been successfully removed from the taxable estate. Assets outside the taxable estate do not receive a step-up in basis at the grantor's death. Beneficiaries inherit the trust's original cost basis, which can create capital gains exposure when they sell. This is one of the central planning tensions in estate tax work: removing assets from the estate saves estate tax but may cost the step-up. For highly appreciated assets, running the numbers on both outcomes before transferring is essential.
How are trust distributions taxed to beneficiaries?
Distributions of trust income are generally taxed to the beneficiary at their individual income tax rate. The trust takes a deduction for the distribution and issues a K-1 to the beneficiary, who reports the income on their own return. Distributions of trust principal (not income) are generally not taxable to the beneficiary. The character of the income — ordinary income, capital gains, tax-exempt interest — flows through to the beneficiary and retains its character on the K-1.
Is estate planning only for wealthy people?
Federal estate tax planning is primarily relevant for estates above the exemption threshold, which excludes the vast majority of Americans under current law. But estate planning more broadly — wills, trusts, beneficiary designations, powers of attorney, and healthcare directives — is valuable at almost any asset level. State estate taxes with lower exemptions can affect estates that would owe nothing federally. And the non-tax benefits of estate planning, including control over asset distribution and avoiding probate, apply regardless of estate size.