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Estate Tax Planning: 8 Strategies To Reduce Taxes

Being prepared for the future is always a good idea. When you have an estate of considerable value, this becomes even more essential. Everyone wants to make sure they're leaving the most possible behind for their loved ones. In this case, that means using tax planning strategies to avoid estate taxes and keep the IRS happy. We'll go through how to avoid estate tax with eight estate tax planning strategies.

Table of contents

Key Takeaways:...Read more

Estate, inheritance, gift and generation-skipping taxes: What’s the difference?...Read more

How to avoid estate tax...Read more

Key Takeaways:

Estate tax planning means using strategies to minimize or avoid paying estate taxes.
Charitable donations and gifts to family and friends are simple ways to lower your bill.
Knowing how to minimize estate taxes is easier when you consult a professional.

Estate, inheritance, gift and generation-skipping taxes: What’s the difference?

Estate tax

When someone passes away, the federal estate tax kicks in if their estate is large enough. At its highest rate, this tax can reach up to 40%. The federal estate tax has an exemption limit that adjusts periodically for inflation and changes in the tax code. For 2024, this exemption is set at $13.61 million for individuals and doubles to $27.2 million for married couples. This is up from the $12.92 million limit in 2023. You won't owe any federal estate tax unless your estate's value exceeds these limits. Additionally, whether you owe estate tax at the state level depends on your state's laws. Some states have their own estate taxes with separate exemption amounts. The federal exemption limit is set to expire after 2025 so estate tax planning becomes essential for every owner.

Inheritance tax

Inheritance tax is a state-level tax that some states impose on the assets that beneficiaries receive from a deceased person. Unlike the estate tax, which is paid from the deceased person's assets before distribution, inheritance tax is paid by the individuals who inherit the assets. Whether an inheritance tax applies depends on the state you live in and the value of the assets you receive. Hiring a tax professional to help with inheritance tax planning is always a good way to make sure your beneficiaries are in good hands.

Gift tax

The gift tax is what you might owe when you give money or other assets to someone else. It's the gift giver's responsibility to pay this tax. However, the IRS allows you to give away a certain amount each year without having to worry about the gift tax. For the 2024 tax year, you can give up to $18,000 per person per year without triggering the gift tax. Married couples can combine their gift tax exclusions, allowing them to give up to $36,000 per recipient. It’s worth noting that any gifts you give count toward your lifetime estate tax exemption.

Generation-skipping tax

The generation-skipping tax is another federal tax that could come into play if you decide to leave your assets to your grandchildren or another younger generation, skipping over your children. This tax is applied at the highest federal estate tax rate which is 40%. One strategy to avoid this tax is to set up a generation-skipping trust. This type of trust allows you to pass down assets to future generations while reducing the overall estate tax liability.

How to avoid estate tax

When looking at how to avoid death tax, it can get complex. There are many ways to redistribute your wealth so pay as little tax as possible, but not every strategy works for every situation. That's why consulting a professional is important.

Infographic entitled Estate Tax Planning Strategies listing eight ways to avoid estate taxes.

1. Make donations to charity

Making charitable donations is one of the easiest estate planning strategies as it is a way to support the causes you care about while also benefiting your tax situation. Giving to a qualified charity can be a smart part of your tax planning for the year you make the donation. Plus, it might even reduce the size of your estate, which can have future tax benefits. If you itemize deductions on your tax return, charity contributions can provide an income tax deduction for the year you make the donation. From an estate tax standpoint, any assets you leave to a qualified charity when you pass away are deducted from the taxable portion of your estate. You can also donate long-term appreciated assets like stocks, bonds or mutual fund shares that you’ve held for more than a year. When you do this, you can deduct their fair market value and avoid paying capital gains tax. Knowing how to avoid death tax by picking qualified charitable organizations and trusts is key.

2. Set up an irrevocable trust

A trust is a legal way to manage and protect your assets. When you set up a trust, you transfer assets into it, and a trustee manages those assets according to your wishes. There are two main types of trusts: revocable and irrevocable. A revocable trust can be changed or even canceled during your lifetime. On the other hand, an irrevocable trust is permanent once you transfer assets into it, meaning you can't change your mind later. One of the main benefits of an irrevocable trust is that it can help reduce the size of your taxable estate. By moving assets into the trust during your lifetime, those assets are no longer considered part of your estate, which can help in avoiding estate taxes. You can also use an irrevocable trust to receive life insurance proceeds after you pass away or to leave money to a charitable organization. However, it’s important to remember that once you place assets into an irrevocable trust, you give up control over them. They’re no longer yours, so be sure you’re ready to make that commitment before you proceed. Many people feel uneasy about irrevocable trusts because they require giving up control over the assets placed in them. However, setting up an irrevocable trust now can allow you to take advantage of the current high estate tax exemption limits. These trusts can be a life insurance trust or a Spousal Lifetime Access Trust (SLAT). As with everything estate tax planning related, get a pro to help. They'll know how to minimize estate taxes without compromising your current lifestyle.

3. Max out your lifetime gift exemption at the earliest

The lifetime gift exemption allows you to give away a significant amount of your assets during your lifetime without paying gift taxes. In 2024, this exemption is $13.61 million per person. This means you can gift up to this amount over your lifetime without incurring any gift taxes. As one of the key estate tax strategies, the gifts you give during your lifetime reduce the size of your estate, which in turn can reduce the amount of estate tax your heirs might have to pay when you’re gone. It's also worth noting that gifting can be a way to see your loved ones enjoy the benefits now. Maybe it’s helping a child buy a home, contributing to a grandchild’s college fund or supporting a favorite charity.

4. Look into Roth IRAs

Roth IRAs are one of the estate tax strategies that many people overlook. Unlike traditional IRAs, contributions to a Roth IRA are made with after-tax dollars, meaning you pay taxes on the money before you put it into the account. However, once your money is in a Roth IRA, it grows tax-free. The qualified withdrawals from a Roth IRA in retirement are also tax-free, which can be a big relief when managing your retirement income. So, how to reduce estate tax? First, Roth IRAs are not subject to required minimum distributions (RMDs) during the original owner's lifetime. This means your investments can continue growing tax-free for a longer period, allowing you to leave more to your heirs. Additionally, Roth IRAs can be passed on to beneficiaries tax-free. Your heirs won't owe income tax on withdrawals from an inherited Roth IRA, which isn’t the case with traditional IRAs. This makes a Roth IRA an excellent way to transfer wealth without adding to your estate’s taxable value.

5. Set up a marital trust

When it comes to avoiding estate tax, married couples have two types of trusts they can use: AB trusts and QTIP trusts. Both of these trusts allow each spouse to make full use of their personal estate tax exemption, ensuring that the surviving spouse is not at a disadvantage. Here’s how it works: Each spouse can place their own assets, along with their share of any community property, into a living trust. The surviving spouse can benefit from these assets during their lifetime, but the original grantor spouse controls what happens to the assets after the surviving spouse passes away.

AB Trust: This type of trust allows the surviving spouse to access the income generated by the trust and, in some cases, the principal investment.
QTIP Trust: This trust does not let the surviving spouse access the trust's principal assets, making it a popular choice when the donor spouse is in a second marriage and has children from a previous marriage.

With a QTIP trust, the children from the first marriage are ensured to inherit their parent's assets. AB trusts are often used when all children are from a single marriage, ensuring that the surviving spouse and children are taken care of. QTIP trusts, on the other hand, are ideal for protecting the interests of children from a previous marriage while still providing for a current spouse.

6. Set up a family limited partnership

A family limited partnership (FLP) is one of the estate tax strategies for families with business interests. Essentially, it's a family-owned holding company that can be structured as either a LP or an LLC. An FLP offers several benefits for families with business interests. It can reduce the overall tax burden by allowing assets to be transferred to family members in lower tax brackets. An FLP also keeps the business within the family, ensuring control stays with family members. It also limits the liability of family partners, protecting their personal assets and making them only responsible for what they have invested in the partnership. The FLP has two types of partners:

General partners: These are usually the parents or grandparents who set up the partnership. They have full control over the management and decision-making of the business.
Limited partners: These are typically the children or grandchildren. Limited partners are passive investors who don’t have control over the business and can’t sell their shares to anyone outside the family.

When the general partners put assets into the FLP, they can gift shares of the partnership to family members. As these shares can’t be sold to non-family members, their marketability is limited. This lack of marketability means that, for tax purposes, the value of these shares can be reduced. This discount could potentially answer the question how to avoid federal estate tax.

7. Make direct payments for medical bills or education

Another effective answer to the question how to avoid federal estate tax is by paying someone else’s medical or educational expenses directly. Whether it’s covering medical bills or tuition for any level of education, from preschool to graduate school, these payments won’t count against the annual gift exclusion or your estate tax exemption. The key is to make sure the checks are written directly to the health care provider or the educational institution. You can continue making these payments as often as you like, which helps lower your taxable estate.

8. Set up a Qualified Personal Residence Trust

A Qualified Personal Residence Trust (QPRT) can be a great way to transfer your home to your spouse while still allowing them to live there after you pass away. With a QPRT, you can place your primary or secondary residence into the trust and continue living in it for a set number of years. So if the value of your home goes up while you're alive, that increase doesn’t get added to the home’s value when it’s eventually gifted to your children or other beneficiaries. This helps reduce the gift tax on your estate, which can be particularly useful if you live in an area where property values are rising quickly. Even in states where property values aren’t growing a lot, a QPRT can still offer benefits if property values rise during the trust term. However, keep in mind that there’s a risk involved. If you pass away before the trust term ends, the intended tax savings might not apply to your beneficiaries. Knowing how to reduce estate tax means doing a lot of research to find solutions that work for your unique situation. This is where an estate planner or tax professional can ease your burden and help you figure out what works.

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