Introduction

Estate planning isn’t just about who inherits—it’s also about what’s left after taxes. While not everyone faces federal estate tax, income and capital gains rules affect nearly every estate. This blog explains the main tax issues that come into play and highlights the traps families can fall into if they assume taxes won’t matter to them.

The Estate Tax

The federal estate tax exemption is currently high—about $13 million per person in 2025. That sounds like more than enough for most families, but the exemption is scheduled to be cut in half in 2026 unless Congress acts. In today’s world of million-dollar homes, six-figure vehicles, and sizable retirement accounts, many families are closer to the line than they realize.

There are two important distinctions:
– Unlimited marital deduction: Spouses can inherit from each other without paying estate tax.
– Other heirs: Children and non-spouse beneficiaries do not receive this benefit and may face estate taxes depending on the size of the estate.

On top of the federal rules, some states impose their own estate or inheritance taxes, often with exemptions as low as $1 million. Families living in high-value property markets may find themselves unexpectedly exposed to these taxes.

Gift Tax Basics

The federal gift tax works hand-in-hand with the estate tax. Key rules include:
– Annual exclusion: You may give up to a set amount per person, per year, tax-free (currently $17,000 per person).
– Lifetime exemption: Larger gifts reduce your lifetime exemption, which is tied to the estate tax exemption.

Gifting during life can reduce the size of your taxable estate, but large gifts count against your exemption and should be planned carefully.

Income Taxes on Inherited Assets

Most inherited assets receive a ‘step-up’ in basis, meaning heirs inherit them at fair market value on the date of death. This step-up limits capital gains tax if the asset is sold. For example, a house bought for $200,000 but worth $1 million at death would have a new tax basis of $1 million for the heirs. If they sell soon after for $1.05 million, they only owe tax on the $50,000 gain.

Step-Up in Basis (Still in Place): Despite proposals to change or eliminate it, the step-up in basis is still in effect as of 2025. This rule is one of the most valuable tax breaks in estate planning because it prevents heirs from being hit with massive capital gains taxes on long-held assets. It’s important to note that retirement accounts such as IRAs and 401(k)s are different—they do not receive a step-up and are taxed as ordinary income when heirs withdraw funds.

Retirement Accounts and RMDs

Special rules apply to inherited retirement accounts:
– Spouses: May roll inherited accounts into their own and delay withdrawals.
– Non-spouse beneficiaries: Generally must empty inherited accounts within 10 years under current law.
– Roth accounts: Distributions are tax-free, but non-spouse heirs are still subject to the 10-year distribution rule.

Understanding these differences is critical for families with significant retirement savings.

Strategies to Reduce Taxes

Several strategies can help reduce tax exposure:
– Roth conversions: Pay taxes now to leave tax-free assets later.
– Gifting: Use annual exclusions and lifetime exemptions to reduce estate size.
– Trusts: Certain trusts can provide tax efficiency and asset protection.
– Charitable giving: Direct bequests to charity may reduce estate taxes while supporting causes you care about.

Which strategies make sense depends on your assets, family situation, and state of residence.

Conclusion

Taxes in estate planning are full of traps for the unwary. The federal exemption may sound high, but it is set to fall—and many states impose their own taxes at much lower levels. While a surviving spouse may inherit without estate tax, children and other heirs face different rules. Beyond estate taxes, income taxes on inherited retirement accounts and capital gains can also reduce what heirs receive.

Key steps include:
1. Understand whether federal or state estate taxes could affect your estate.
2. Learn how different assets are taxed for your heirs.
3. Work with professionals to use strategies such as gifting, Roth conversions, or trusts to minimize taxes.

With good planning, you can keep more of your legacy in your family’s hands instead of the government’s.