Chapter 23: Estate Tax vs. Inheritance Tax

Updated for the 2025 One Big Beautiful Bill Act (OBBBA). The federal estate tax exemption is now $15M per individual / $30M per married couple, permanent and indexed for inflation. If you read an older estate-planning resource that warned about a 2026 "sunset" to ~$7M — that sunset was averted. Plan accordingly.

First, the good news for most readers

Most American families do not pay federal estate tax. This sounds like a relief, and mostly it is. It's also a caveat to remember: for most of the country, this chapter is mostly informational rather than immediately actionable.

But "most" is not "all." If your family's estate is substantial, or if you live in a state with its own estate or inheritance tax, the rules in this chapter matter enormously — and getting them wrong can cost six or seven figures.

This chapter is your guide to what applies to you.

Two different taxes

People use "estate tax" and "inheritance tax" interchangeably. They're different things.

Estate tax is paid by the estate, before distribution. The estate calculates its net taxable value, applies any exemption, pays tax on the excess. Beneficiaries receive what's left.

Inheritance tax is paid by the beneficiaries, after they receive the inheritance. The tax rate often depends on the relationship — closer relatives pay less, more distant relatives pay more.

The federal government has estate tax only (no inheritance tax). Some states have one, some have the other, some have both, most have neither.

Federal estate tax

The federal estate tax applies to the value of everything the decedent owned at death — real estate, investments, business interests, life insurance (if owner and insured), retirement accounts, personal property, digital assets.

The 2026 exemption is approximately $15 million per individual, $30 million per married couple. These numbers are indexed for inflation and change annually. The 2025 One Big Beautiful Bill Act (OBBBA) made the high exemption permanent and stepped it up from the prior $13.99M level, so the "sunset to ~$7M" landmine that estate planners warned about for years is no longer a planning concern. The exemption now grows with inflation indefinitely.

If your estate is under the exemption, you owe no federal estate tax. For the vast majority of Americans, this is the case.

If over the exemption, the tax rate on the excess is up to 40%.

Two critical technical points:

Portability. The unused exemption of a first-to-die spouse can be transferred to the surviving spouse. Must be elected on a timely-filed Form 706 estate tax return, even if no tax is owed. Miss the election, lose the option.

The marital deduction. Assets passing to a US-citizen surviving spouse are unlimited deduction — no estate tax at first death. But the surviving spouse's estate at their later death is then larger, so estate tax may apply then.

Strategies for reducing federal estate tax

For families over the threshold, several strategies reduce estate tax:

1. Annual exclusion gifts. $19,000 per recipient per year (2025; indexed annually for inflation). Gifts under this amount are not taxable and don't use up the lifetime exemption. Both spouses can give separately to the same recipient, doubling the effective amount.

2. Direct tuition and medical payments. Pay tuition directly to the educational institution or medical expenses directly to the provider. These don't count as gifts at all.

3. Lifetime exemption gifts. You can use your $15M exemption during life by making larger gifts, reported on gift tax returns. Reduces your estate by the amount gifted plus appreciation. Important: lifetime exemption used during life reduces what's available at death — they share one pool.

4. Grantor Retained Annuity Trusts (GRATs). Advanced technique that transfers appreciation to heirs at low tax cost.

5. Qualified Personal Residence Trusts (QPRTs). Removes the home from your estate while letting you live in it for a term.

6. Irrevocable Life Insurance Trusts (ILITs). Holds life insurance outside the estate so proceeds aren't subject to estate tax.

7. Charitable remainder trusts. Gives assets to charity at death; income to beneficiaries during life.

8. Family limited partnerships / LLCs. Discounts for minority interests and lack of marketability can reduce taxable value.

9. Spousal lifetime access trusts. Allow one spouse to fund an irrevocable trust for the other, preserving access while removing assets from estates.

These are specialist tools. If your estate is over the federal exemption, you need an attorney experienced in high-net-worth estate planning.

What changed in 2025 (the OBBBA story)

For the better part of a decade, estate planning books warned about "the sunset" — the scheduled 2026 expiration of the doubled-exemption from the 2017 Tax Cuts and Jobs Act. Under the old sunset rules, the federal estate tax exemption was supposed to drop from ~$13.99M back to roughly $7M per individual. Families in the $7M-$14M range did a lot of expensive planning to lock in the higher exemption before it fell.

That sunset did not happen.

In July 2025, Congress passed and the President signed the One Big Beautiful Bill Act (OBBBA). The law made the higher exemption permanent and stepped it up to $15 million per individual ($30M per married couple) effective January 1, 2026, with continued inflation indexing going forward. There is no longer a scheduled cliff.

Planning implications now:

• If your estate is under $15M (individual) or $30M (married), federal estate tax is not your concern. Focus on state estate tax, basis planning, and family dynamics — not federal exemption planning.
• If your estate is over the new exemption, the strategies in this chapter still apply, but without the urgency the pre-OBBBA sunset created.
• If you already executed "use it or lose it" lifetime gifts before OBBBA passed — those are still good. Exemption used is exemption used. You didn't waste anything; you just no longer needed to do it in a panic.
• The 40% top rate above the exemption is unchanged.

A note for the long view. Federal estate tax exemption levels have always been subject to political revision. OBBBA made the current exemption permanent — meaning until a future Congress changes it. Plan for the long term but check the numbers annually.

State estate and inheritance taxes

As of 2026, about a dozen states have an estate tax, inheritance tax, or both. The list changes as states adopt or repeal, but roughly:

States with estate tax (estate pays):

• Connecticut, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington.

States with inheritance tax (beneficiary pays):

• Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania. (Iowa fully repealed its inheritance tax effective January 1, 2025. If you read an older source listing Iowa, it's out of date.)

States with both (Maryland):

• Maryland has both.

State exemptions are much lower than federal. Most state exemptions range from $1 million to $6 million. Some have no specific exemption but different rates.

State tax rates:

• Most state estate taxes top out at around 16%.
• Inheritance tax rates often depend on relationship — spouses and lineal descendants pay less (sometimes 0%); siblings pay more; distant relatives or non-relatives pay the most (up to 15-18% in some states).

State rules change. States regularly adjust their estate/inheritance tax laws. Check current rules for your state.

State tax planning strategies

For families with potential state estate tax exposure:

1. Domicile planning. If you can move to a no-tax state, significant savings possible. But "domicile" is more than "I bought a house there" — you must genuinely relocate (voter registration, driver's license, primary residence, etc.).

2. Avoid owning property in tax states if possible. Real estate in a tax state can subject you to that state's tax even if you don't live there.

3. State-specific trusts. Some states allow specific trust structures that reduce state estate tax.

4. Inheritance tax mitigation. If living in an inheritance tax state, consider leaving more to close relatives (who pay lower rates) and less to distant relatives or non-relatives (who pay higher rates). Counterintuitive but legal.

5. Gift early, gift often. State tax thresholds are lower than federal. Annual gifting reduces state estate tax exposure.

Generation-skipping transfer tax (GST)

Beyond estate and inheritance taxes, there's the federal generation-skipping transfer tax. Purpose: to prevent wealthy families from avoiding estate tax by skipping generations (leaving directly to grandchildren to bypass the tax at the child level).

GST applies to transfers to beneficiaries two or more generations below the donor (grandchildren, great-grandchildren, unrelated persons more than 37.5 years younger).

GST rate: 40% on the transfer.

GST exemption: Equal to the federal estate tax exemption (~$15M individual / $30M couple effective 2026, indexed annually). Must be allocated properly on tax returns.

Planning implications:

• Wealthy families leaving assets directly to grandchildren need GST-conscious planning.
• Dynasty trusts — designed to skip multiple generations — require careful GST allocation.
• Missed GST planning can be devastating for larger estates.

This is high-end territory. If it applies to your family, you need specialist counsel.

Life insurance and estate tax

Life insurance owned by the decedent is included in their estate for estate tax purposes. This surprises many people.

If your estate is over the estate tax threshold, and you own your own life insurance, the death benefit adds to your taxable estate. A $2M life insurance policy on a decedent with a $12M estate means a $14M taxable estate — potentially subjecting them to estate tax that wouldn't have applied to either the estate or the insurance separately.

Solution: Irrevocable Life Insurance Trust (ILIT). The trust owns the policy. You (the insured) contribute premiums to the trust. At your death, proceeds go to beneficiaries via the trust, outside your estate.

Caveats:

• The trust must be properly structured (attorney required).
• Transfers of existing policies to an ILIT trigger a 3-year "lookback" — if you die within 3 years of transfer, the policy is pulled back into your estate.
• Contributions to the trust may require using annual exclusions via "Crummey" notices to beneficiaries.

ILITs are standard tools for high-net-worth estate planning. If you have life insurance and an estate that might owe tax, consider one.

Property stepped up vs. not

A tax feature that often works in families' favor: step-up in basis at death.

For capital assets (real estate, stocks, mutual funds, fine art, etc.) held by the decedent at death, the cost basis "steps up" to the fair market value as of date of death.

Impact: Heirs can sell shortly after inheritance with minimal or no capital gains tax, regardless of the decedent's original purchase price.

Exception: This does NOT apply to retirement accounts (traditional IRAs, 401(k)s). These remain "income in respect of a decedent" — heirs pay ordinary income tax on distributions. No step-up.

Planning implications:

1. Hold highly appreciated assets until death. If you bought Apple stock in 1995, selling during life triggers massive capital gains tax. Holding until death gives heirs a clean cost basis.

2. Leave appreciated assets to heirs, not charity. Charity doesn't need step-up (no income tax). Give cash or retirement to charity; give appreciated assets to heirs.

3. Leave retirement accounts to charity if you're charitable. Charity doesn't pay income tax; heirs would. IRA-to-charity is tax-efficient.

4. Get appraisals at death. Document the step-up basis for future heir-side sales.

Installment payment of estate tax

If estate tax is owed and the estate's primary asset is illiquid (a family business, real estate, etc.), the estate can pay the tax in installments rather than liquidating the asset.

Section 6166 allows up to 14-year installment payments for qualifying estate tax where a closely-held business is a substantial portion (>35%) of the estate.

Requirements:

• Closely-held business interests.
• 35%+ of adjusted gross estate.
• Proper election on estate tax return.
• Interest applies to unpaid balance.

This provision can save a business from being sold to pay estate tax.

Common estate tax mistakes

From my observation:

1. Not filing Form 706 for portability. Even when no tax is owed, the first-to-die spouse's executor should file Form 706 to preserve portability of the unused exemption. Miss this, the surviving spouse may face estate tax later that could have been avoided.

2. Forgetting state estate tax. Families focused on federal exemption forget their state's lower threshold.

3. Insurance owned personally by the insured. Inclusion in the estate can push above exemption.

4. Improper gift documentation. Lifetime gifts not reported on Form 709 when required.

5. Last-minute transfers. Transfers within 3 years of death can be pulled back into the estate.

6. Inadequate valuation support. Low valuations challenged and adjusted by IRS lead to unexpected tax and possibly penalties.

7. Delayed filing and payment. Estate tax returns are due 9 months after death. Extensions available but interest accrues.

Do you need estate tax planning?

Ask yourself:

Is your estate (or your parents' combined estate) over $15 million (individual) or $30 million (married)?

If yes, this matters. You need specialist planning.

Do you live in a state with its own estate tax?

Check current state threshold. Many are lower than federal.

Do you have significant life insurance that you own?

If so, may push you over.

Are you anticipating significant inheritance yourself?

Your estate may grow unexpectedly.

Are you selling a business or expecting a liquidity event?

Planning now matters.

If any of these, engage an attorney and CPA experienced in estate tax.

If none of these apply, estate tax probably isn't your issue. Focus on other aspects of estate planning (probate avoidance, family dynamics, documentation) that matter more for your situation.

What to do this week

If you think estate tax may apply to you:

1. Calculate your estate size today. Include everything: house, investments, retirement, life insurance, business, etc.
2. Research your state's estate/inheritance tax rules.
3. If potentially over any threshold, consult an estate tax specialist.
4. Review life insurance ownership — would an ILIT help?
5. Consider your gifting strategy — are you using annual exclusion and lifetime exemption effectively?

If you're administering an estate potentially over any threshold:

1. Engage estate tax CPA immediately. Deadlines are tight.
2. Get professional appraisals of significant assets for step-up basis and tax valuation.
3. File Form 706 for portability even if no tax is owed (spouse's surviving exemption).
4. Consider installment payment for illiquid estates.
5. Watch deadlines — 9 months from death for estate tax return, with extension possible.

If you're not over any threshold:

1. Confirm you're really not. Double-check state rules particularly.
2. Focus on other estate planning priorities addressed in other chapters.
3. Periodically reassess as estate size grows.

Next chapter: income tax considerations for the estate and for heirs. The details that matter even for families not subject to estate tax.