Do Trusts Really Need to Pay Inheritance Tax? – Avoid This Mistake + FAQs

No – trusts themselves typically do not pay “inheritance tax.” Inheritance tax is a state-level tax on beneficiaries, not on the trust or estate.

At the federal level, there is no inheritance tax at all (only a federal estate tax on very large estates). Whether any tax is owed when someone dies with a trust depends on the trust’s type and the applicable laws:

• Revocable Trusts: A revocable living trust is considered part of your estate for tax purposes. Its assets won’t avoid estate taxes if your estate exceeds federal or state thresholds. And if you live in a state with an inheritance tax, the beneficiaries of a revocable trust face the same tax as if they inherited through a will. (The trust’s main benefit is avoiding probate, not taxes.)
• Irrevocable Trusts: Transferring assets to a properly structured irrevocable trust during your lifetime can remove those assets from your taxable estate. That means they won’t be subject to estate tax at your death. In states with inheritance tax, assets given away to an irrevocable trust well before death may bypass inheritance tax too, since the assets aren’t considered part of your estate when you die. (Caveat: if you retain control or benefit from the trust, or transfer assets shortly before death, taxes can still apply.)
• Beneficiaries Pay Tax, Not Trusts: Inheritance tax (where it exists) is charged to the recipient of an inheritance. So if a trust leaves money to someone in a state with inheritance tax, that person might owe tax – but the trust entity itself doesn’t pay it. For estate taxes, the estate (or trust holding the estate assets) pays the tax bill before distributing to heirs.

Bottom line: Most trusts do not pay inheritance tax themselves. Instead, the impact of taxes comes down to how the trust is set up and who the beneficiaries are. Next, we’ll dive deeper into key terms and different types of trusts, and how each is treated under U.S. tax laws.

Estate Tax vs. Inheritance Tax (Key Terms)

To grasp how trusts and taxes interact, you need to understand the difference between an estate tax and an inheritance tax, as well as some other key terms:

• Estate Tax: A tax on the total value of a deceased person’s estate before the assets go to heirs. The federal government imposes an estate tax on estates above a certain high exemption (over $12 million per individual as of 2023). A dozen states also have their own estate taxes, often with lower thresholds (for example, Massachusetts taxes estates over $1 million). Estate tax is paid out of the estate’s funds by the executor or trustee – heirs themselves don’t directly pay it, though it can reduce what they receive.
• Inheritance Tax: A tax some states charge to individuals who inherit assets. Unlike an estate tax, an inheritance tax is paid by the beneficiary who receives the money or property. There is no federal inheritance tax in the U.S. – it only exists at the state level. As of now, six states impose inheritance taxes (Pennsylvania, New Jersey, Nebraska, Maryland, Kentucky, and Iowa). In those states, the tax rate depends on your relationship to the deceased and the amount inherited. (Close relatives like spouses – and often children – typically pay little or nothing, while distant relatives or unrelated heirs may pay higher rates.)
• Trust: A legal arrangement where one party (a trustee) holds and manages assets for the benefit of others (beneficiaries). The person who creates the trust (the grantor) sets its terms. Trusts come in many forms (revocable, irrevocable, etc.), and their treatment for tax purposes varies. Assets in a trust might be part of the grantor’s estate or not, depending on the trust type and how it’s structured.
• Probate: The legal process of validating a will and settling an estate. Assets in a revocable living trust avoid probate court, which can save time and fees. However, avoiding probate does not mean avoiding taxes – probate and tax are separate issues.
• Gift Tax: A federal tax on large transfers of wealth made during one’s lifetime. This goes hand-in-hand with the estate tax – together they form the unified federal estate and gift tax system. If you give assets to an irrevocable trust while alive, it may count as a gift and use some of your lifetime gift/estate tax exemption. (For 2023, the combined estate/gift exemption is $12.92 million per person.) Gifts below annual or lifetime exemption limits incur no tax but reduce your remaining estate exemption.
• Generation-Skipping Transfer (GST) Tax: A special federal tax on transfers (during life or at death) that skip a generation – for example, leaving assets in trust for your grandchildren. This exists to prevent families from avoiding estate tax by “skipping” the children’s generation. Like the estate tax, GST tax generally applies only above a high exemption (also about $12 million) at a 40% rate. Certain trusts known as dynasty trusts are designed to avoid this by using the GST exemption.

Understanding these terms sets the stage for how trusts play into tax planning. Now, let’s look at the main types of trusts – and how each is treated when it comes to inheritance and estate taxes.

Trust Types and Their Tax Treatment

Not all trusts are created equal. Some trusts offer significant tax advantages, while others are mainly for convenience and control. Below we explore common trust types – revocable, irrevocable, grantor, living, dynasty, charitable, and more – and explain how each is handled under federal and state tax laws when someone passes away.

Revocable (Living) Trusts – Great for Probate, Not for Taxes

A revocable living trust is a trust you create during your lifetime that you can change or cancel at any time. You (the grantor) typically also serve as the trustee and beneficiary while alive, retaining full control over the assets. Because you can revoke it and still own the property, a revocable trust’s assets are considered yours for tax purposes.

• Federal Estate Tax: Assets in a revocable trust are included in your gross estate when you die, just as if you owned them outright. If the value pushes your estate above the federal estate tax exemption, those trust assets will be taxed by the IRS at the 40% estate tax rate on the amount above the exemption. (If your estate is below the exemption, no federal estate tax applies – with or without a trust.)
• State Estate/Inheritance Tax: Similarly, for state taxes, revocable trust assets don’t get any special break. If your state has an estate tax and your estate value exceeds the state’s threshold, the trust assets are taxed. If your state has an inheritance tax, the beneficiaries of the revocable trust must pay whatever inheritance tax the state law requires, based on their relationship to you and the amount inherited. In short, a revocable trust does not shield assets from estate or inheritance taxes.
• Primary Benefit – Probate Avoidance: The big advantage of a revocable living trust is avoiding probate, not reducing taxes. When you die, the assets in the trust pass directly to your named beneficiaries per the trust terms, without having to go through the court probate process that a will would require. This can save time, legal fees, and keep your financial affairs private. But it won’t save estate or inheritance taxes if those would have applied otherwise.
• Example: Suppose you live in Pennsylvania (which has an inheritance tax) and have $500,000 in a revocable living trust that will go to your adult daughter. When you die, that $500,000 is part of your estate (for estate tax, it’s well below federal and PA thresholds, so no estate tax). However, your daughter will still owe Pennsylvania’s 4.5% inheritance tax on the $500,000 she inherits from the trust, which comes out to $22,500. If instead you had left her $500,000 by a will, she’d owe the exact same tax. The trust simply lets her receive it without probate delays.

Takeaway: A revocable trust is great for convenience and probate avoidance, but it won’t save inheritance tax in a state like PA. Jane would need different strategies (like gifting during life or insurance planning) to reduce that tax.

Irrevocable Trusts – Removing Assets from Your Taxable Estate

An irrevocable trust is a trust that, once you create and fund it, you (generally) cannot change or revoke. You give up ownership and control of the assets, and a separate trustee manages them for the beneficiaries. Because you no longer own the assets, properly set up irrevocable trusts can provide major tax advantages:

• Estate Tax Benefits: Assets transferred into an irrevocable trust during your lifetime are usually excluded from your estate when you die – meaning they are not counted when calculating estate tax. By moving wealth out of your name and into the trust, you “freeze” its value for estate tax purposes. Any future appreciation happens inside the trust, escaping estate tax. This is why high-net-worth individuals use irrevocable trusts to reduce or avoid estate taxes. For example, if you gift $5 million of assets into an irrevocable trust today, that $5 million (and all future growth on it) won’t be in your estate. If your remaining estate is under the exemption, you could potentially owe zero estate tax, whereas without the trust you might have faced a 40% tax on everything above the limit.
• Using the Gift Tax Exemption: Moving assets to an irrevocable trust is often treated as a gift for tax purposes. You may need to file a gift tax return, but as long as you have not exceeded your lifetime gift/estate exemption (currently in the millions of dollars), you won’t owe actual gift tax. Instead, the amount of the gift just reduces your remaining exemption. Essentially, you’re using some of your estate tax exemption early, to get assets out of your estate.
• State Tax Benefits: For state death taxes, irrevocable trusts can also help. If you live in a state with an estate tax (like New York or Oregon), transferring assets to a trust can keep your estate under the state’s taxable threshold. If your state has an inheritance tax, giving assets away before death means those assets aren’t “inheritances” when you die. Many inheritance tax states exempt gifts made beyond a certain period before death. (For instance, Pennsylvania does not tax gifts made more than one year prior to death – so funding an irrevocable trust and living at least a year after can avoid PA inheritance tax on those assets.)
• No Inheritance Tax on Trust Distribution: When an irrevocable trust is created during life, the beneficiaries’ eventual receipts from the trust are generally not treated as inheritances from you at death. They are distributions from a trust. The key is you didn’t own the assets at death. Therefore, states can’t impose inheritance tax on those trust assets at your death (because legally the trust – not you – owned them). However, if you die within a state’s look-back window for gifts, or if you retained certain interests, taxes could still apply. Always follow the specific state rules.
• Loss of Control & Other Trade-offs: The trade-off for these tax perks is that you truly give up control and beneficial use of the assets. You can’t take the assets back easily or change your mind. Also, any asset you gift into an irrevocable trust typically will not receive a step-up in cost basis at your death, since it’s not in your estate. That means the original cost basis carries over, and beneficiaries might owe capital gains tax on the asset’s appreciation when they eventually sell. In contrast, if you kept the asset until death (in a revocable trust or outright), your heirs would get a full step-up in basis (resetting the value, potentially reducing capital gains taxes).
• Example: Imagine you have a $10 million life insurance policy. If you own it at death, that $10 million payout would be part of your taxable estate. But if you set up an Irrevocable Life Insurance Trust (ILIT) and transfer the policy to it (and survive at least three years after the transfer, per IRS rules), the insurance proceeds can be excluded from your estate. The trust receives the $10 million at your death and can pass it to your heirs free of estate tax and free of any state inheritance tax (since it wasn’t your asset at death). The result: your heirs get the full $10 million, whereas had you owned the policy, a significant portion could have been lost to estate tax.

In summary, irrevocable trusts are powerful tools for legally bypassing estate and inheritance taxes, but they require giving up ownership well in advance. They’re most useful for those with substantial assets that risk exceeding tax thresholds or for specific assets like life insurance or business interests that you want to exclude from your estate.

Takeaway: An irrevocable trust can significantly cut estate taxes for a wealthy individual. It requires using up some of the estate/gift exemption while alive and foregoing control of the assets. It’s a common technique for estates that are (or will be) above the exemption.

Grantor Trusts – Who Pays the Income Tax?

The term “grantor trust” isn’t a type of trust you set up for a specific goal, but rather a tax classification. A grantor trust simply means that for income tax purposes, the trust’s income is treated as the grantor’s income. The grantor (the person who created the trust) must report all the trust’s interest, dividends, and other income on their personal tax return, and pay taxes on it, even if the income stays in the trust.

• Revocable Trusts are Grantor Trusts: If you create a revocable living trust, it is by definition a grantor trust. You still control the assets, so the IRS ignores the trust as a separate taxpayer. There’s no change to your income taxes during your life – all trust earnings are just your earnings.
• Some Irrevocable Trusts are Grantor Trusts Too: It’s possible to set up an irrevocable trust that is intentionally treated as a grantor trust for income tax, while still removing the assets from your estate for estate tax. For instance, you might give away assets to an irrevocable trust (so they’re out of your estate), but retain a power like the ability to swap assets of equal value with the trust. That retained power makes it a “grantor trust” for income tax under IRS rules (you pay the trust’s income tax bill each year), yet if structured properly, the trust assets are not counted in your estate. This strategy is often called an Intentionally Defective Grantor Trust (IDGT). Paying income tax on trust earnings each year further reduces your estate and lets the trust grow unhindered by taxes – effectively a gift of the tax payments.
• No Impact on Estate/Inheritance Tax: Whether a trust is a grantor trust or not doesn’t directly change inheritance or estate tax outcomes. It mainly affects who pays income tax on trust earnings while the grantor is alive. A non-grantor trust pays its own income taxes (often at high trust tax rates), while a grantor trust’s income is taxed to the grantor. After the grantor’s death, if the trust continues, it usually becomes a separate taxpayer (no longer a grantor trust) and either the trust or beneficiaries will pay income tax on any future trust income. But in terms of the one-time transfer at death (estate or inheritance tax), the key factor is whether the trust was revocable or irrevocable (owned by the grantor or not), not the grantor trust status.

In summary, “grantor trust” status is an income tax concept. All revocable trusts are grantor trusts. Many irrevocable trusts are not grantor trusts (the trust pays its own taxes), but some are structured to be grantor trusts for strategic reasons. This doesn’t change whether the assets face estate or inheritance tax – that still depends on if the trust was in your estate or removed from it.

Living Trusts (Inter Vivos Trusts) – Just Another Name for Trusts Made During Life

The term living trust (or inter vivos trust) simply refers to any trust you create while you’re alive, as opposed to a trust that is created by your will at your death (a testamentary trust). Most of the trusts discussed (revocable or irrevocable) are living trusts. The popular “living trust” in estate planning usually means a revocable living trust – a trust you set up to hold your assets during life and pass them on at death without probate.

• Tax Treatment: A revocable living trust has the tax characteristics we covered above under revocable trusts (no tax savings, just probate avoidance). If someone refers to a “living trust” they almost always mean a revocable trust. An irrevocable trust can also be a living trust (since you made it during life), and it has the tax effects described for irrevocable trusts.
• Testamentary Trusts: By contrast, a trust that is formed under your will at death – known as a testamentary trust – only comes into being after your estate goes through probate. For example, you might direct in your will that after you die, a trust is to be set up for your minor children. Since these trusts spring from the will, the assets fund the trust after being part of your estate. Any estate taxes would be assessed before funding the trust. And if those assets go to beneficiaries in an inheritance-tax state, the tax would be assessed (and usually paid by the executor) at that time. The trust then continues for the beneficiaries with whatever is left, according to your will’s instructions.

In short, “living trust” usually means a revocable trust you set up now. Its purpose is convenience and probate avoidance, not tax reduction. Other trusts created during life (which are “living” too) can have tax benefits if irrevocable.

Dynasty Trusts – Multi-Generation Protection (Avoiding Repeated Estate Taxes)

A dynasty trust is a long-term irrevocable trust designed to pass wealth down through multiple generations without incurring estate taxes at each generational level. In essence, you put assets into a dynasty trust once, and if structured correctly, those assets can benefit your children, grandchildren, and beyond, without ever being part of anyone’s taxable estate in the future.

• Generation-Skipping Tax Considerations: Normally, if you try to skip a generation (leave assets directly to grandkids, for example), the GST tax may apply. However, each individual has a GST tax exemption equal to the estate tax exemption (over $12 million currently). In a dynasty trust, you would allocate sufficient GST exemption to the trust when you fund it, so that the transfers to your grandchildren and further descendants are covered and no GST tax will apply down the line. Once properly set up and exempted, the trust can last for generations (some states allow trusts to continue for hundreds of years or even perpetually).
• No Estate Tax for Future Generations: Because the assets are in the trust and not owned by any beneficiary outright, when your children die, nothing in the trust is counted in their estate – it passes directly under the trust terms to the next generation (or continues to be held for them). This avoids the estate tax that would otherwise hit at each death if the assets were passed outright each time. Essentially, you pay estate tax (if any) once when you initially fund the trust (or use your exemption to avoid it), and then the trust assets skip estate taxation thereafter.
• State Taxes: Dynasty trusts can also avoid state estate taxes for future generations in the same way. If the trust is properly structured and perhaps located in a state with favorable trust laws (Delaware, South Dakota, etc.), it can minimize state-level taxes as well. Inheritance tax generally wouldn’t apply to transfers within the trust after the initial funding, since no one is “inheriting” at each generational transfer – the trust continues seamlessly.
• Control and Protection: Aside from tax benefits, dynasty trusts are often used to protect family wealth from creditors, divorces, or spendthrift heirs. The trust can specify how and when beneficiaries get access to the funds across generations.
• Example: You establish a dynasty trust with $10 million for your descendants. You allocate your generation-skipping tax exemption to cover that $10 million. The trust might provide income to your children for life, then to your grandchildren, and so on. Assuming you stayed under your exemptions, no estate or GST tax was due when you funded the trust. Years later, when your child dies, the trust assets pass to or for the grandchildren without any estate tax (because your child didn’t own them). The inheritance tax in any state also doesn’t bite because technically nothing “passed” upon the parent’s death – the trust already held it. This way, the $10 million can continue growing and benefiting the family without being reduced by 40% estate taxes every generation.

Dynasty trusts are a complex but powerful tool for very long-term family wealth preservation. They require careful planning to ensure the initial transfer is tax-efficient (using exemptions) and compliance with both federal GST rules and state laws. For families that won’t exceed estate tax limits, a dynasty trust may not be necessary, but for very wealthy families it can save tens of millions in future taxes over time.

Charitable Trusts – Giving to Save on Taxes

Charitable trusts are trusts that involve a charitable organization as one of the beneficiaries. They are often used to simultaneously achieve philanthropic goals and tax savings. Two common types are Charitable Remainder Trusts (CRTs) and Charitable Lead Trusts (CLTs), which flip the timing of benefits between charity and family:

• Charitable Remainder Trust (CRT): You transfer assets into an irrevocable trust that provides an income stream to you (or other named beneficiaries) for a term of years or for life. After that, whatever is left (the “remainder”) goes to a designated charity. With a CRT, you get an immediate income tax charitable deduction for the present value of the remainder going to charity. For estate tax, those assets are removed from your estate (reducing your taxable estate). When you die, the remaining assets pass to charity – which means they aren’t subject to estate or inheritance tax. (Any payments you received during life would have been taxed as income normally, but that’s separate.) A CRT is a way to diversify or sell appreciated assets tax-efficiently as well, since the trust, as a charitable entity, can sell assets without immediate capital gains tax and then pay you income.
• Charitable Lead Trust (CLT): This is kind of the opposite structure: the trust pays an income stream to a charity for a number of years, and then the remainder goes to your family beneficiaries. The benefit here is primarily in gift/estate tax: if structured correctly, the value of the eventual gift to your heirs can be significantly reduced for tax purposes (or even zero), using up little of your exemption – because the charity got the lead payments, the taxable value of what the family will get is lower. All growth in the trust above the IRS assumed rate can pass to your heirs tax-free. When you die, the trust continues paying the charity for its term, then ends with assets going to your heirs without further tax (the “inheritance” to them was basically already handled at the time of the trust’s creation in terms of tax).
• Wealth Replacement via Life Insurance Trust: Another charitable strategy: someone might establish a CRT to get income and a deduction, benefiting charity at death, and simultaneously use the increased cash flow or tax savings to fund a life insurance policy (often held in an ILIT) for their children. The charity gets the trust assets and the kids get the insurance proceeds tax-free, effectively replacing the wealth, but you got to deduct the gift to charity and reduce your estate.

In summary, charitable trusts can reduce your taxable estate and generate income or gift tax benefits, but they commit a portion of your wealth to charitable causes. They are complex instruments subject to many rules. From an inheritance tax perspective, assets that ultimately go to a charity are not considered a taxable inheritance (no state inheritance tax on charitable bequests), and using charitable trusts can significantly lower what would otherwise be taxed in your estate.

Other Trusts and Tax Considerations

There are many other specialized trusts in estate planning, but a few notable ones in the context of taxes:

• Marital and Bypass Trusts: Married couples often use trusts to maximize estate tax savings. For example, a bypass trust (also known as a credit shelter trust or family trust) can be set up at the first spouse’s death to hold an amount up to the estate tax exemption, passing free of tax, and then give the surviving spouse benefits from that trust without including it in the survivor’s estate. The rest can go to the spouse outright or in a marital trust (like a QTIP trust) that qualifies for the marital deduction (no tax at first death, but taxed at second death). The result is minimizing overall estate tax by utilizing both spouses’ exemptions. These trusts don’t avoid tax entirely, but they defer or reduce it by design.
• Special Needs Trusts: These trusts are not about tax avoidance but about providing for a disabled beneficiary without disqualifying them from government benefits. Generally, funding a special needs trust doesn’t have unique estate or inheritance tax advantages (aside from potentially using your annual gift tax exclusion to fund it). It’s more about ensuring the inheritance is managed properly.
• Qualified Personal Residence Trust (QPRT): An irrevocable trust to transfer a house to heirs at a discounted gift tax value, while you retain the right to live there for a term of years. This is a technique to remove a valuable home from your estate at a lower tax cost. If you survive the retained term, the house is out of your estate (plus any growth in value after transfer is tax-free). If you don’t, it comes back into your estate (so there’s some risk).
• Grantor Retained Annuity Trust (GRAT): A short-term irrevocable trust where you retain an annuity payment for, say, 2–5 years, and at the end, any remaining value goes to your beneficiaries. It can be designed so that the gift value for tax purposes is minimal. If the assets grow faster than a certain IRS assumed rate, that excess passes to your heirs tax-free. GRATs are often used to transfer future appreciation out of an estate without using much exemption.
• Trusts for Minors (UTMA/UGMA and 2503(c) Trusts): Minor children often can’t inherit directly, so trusts or custodial accounts are used. These generally don’t have estate tax savings (other than maybe using the annual gift exclusion to fund them). They’re mainly for management until the child is of age.

Each of these has specific uses and rules, but the core takeaway is that trusts can be crafted to meet various goals – and some of those goals involve minimizing taxes. However, every trust that effectively saves estate or inheritance tax does so by legally shifting ownership or timing of transfers (often well before death or by taking advantage of exemptions/deductions). If a trust sounds “too good to be true” as a tax silver bullet without any trade-offs, be skeptical. Always consult an estate planning expert to use the right trust for the right purpose.

Federal Tax Laws: How Trusts Are Taxed by the IRS

Let’s focus on the federal side first. The U.S. federal government does not impose any inheritance tax on beneficiaries – so whether you inherit via a trust or directly, you won’t owe the IRS just for receiving an inheritance. The primary federal death tax is the estate tax, which is charged to the estate of the person who died.

Here are the key federal rules to know:

• Federal Estate Tax Exemption: As of 2023, the federal estate tax exemption is $12.92 million per individual (rising to $13.61 million in 2024 due to inflation). This means an individual can leave up to that amount to heirs free of federal estate tax. Married couples can effectively double that (one way is by using “portability” or by trust planning). Estates above the exemption pay a hefty tax (40%) on the excess. Only a very small percentage of wealthy estates – less than 0.1% of all estates – actually end up paying federal estate tax under current law.
• Trusts and Estate Inclusion: If you have a revocable trust, all its assets count toward your estate tax exemption limit because you still own them. If you have an irrevocable trust that you funded during life, those assets are typically not included in your estate (assuming you relinquished enough control and survived any look-back periods). For example, assets in a properly structured irrevocable life insurance trust or a completed gift trust will not be tallied in that $12.92 million calculation at death.
• Marital Deduction: If you leave assets to your spouse (and your spouse is a U.S. citizen), those assets are not taxed at your death thanks to the unlimited marital deduction. This applies whether you leave them outright or in a special marital trust (like a QTIP trust). The estate tax is deferred until the surviving spouse’s death. Many trusts for a spouse are set up to take advantage of this – for instance, a QTIP marital trust gives income to the spouse and then to children, qualifying for the marital deduction now but being taxable in the spouse’s estate later.
• Gift Tax and Trusts: If you place assets into an irrevocable trust while alive, you may trigger the gift tax. The federal gift tax shares the same $12.92 million exemption (it’s unified with the estate tax). Each year, you also have an annual gift exclusion ($17,000 per recipient in 2023) which you can give without even needing to use the lifetime exemption. Funding certain trusts (like a life insurance trust or a children’s trust) can use those exclusions or exemption. If you stay within the limits, you won’t owe any gift tax out of pocket – you’re just reducing the amount you can pass tax-free at death.
• Three-Year Look-Back (Life Insurance): A special federal rule to note: if you transfer a life insurance policy to an irrevocable trust and die within three years, the policy proceeds are pulled back into your estate for estate tax purposes. This is to stop deathbed transfers. So, plan such moves well in advance.
• Generation-Skipping (GST) Tax: If your trust is skipping a generation (benefiting grandkids or beyond), the federal GST tax might apply at a flat 40% beyond the separate GST exemption (around $12 million as well). However, with careful planning, you allocate your GST exemption to a dynasty trust when you set it up, so no GST tax will be due later. If a trust isn’t structured to be GST-exempt and it makes a distribution to a “skip person” (like a grandchild), either the trust or the distribution may incur GST tax. This area is complex – basically, know that leaving significant assets two generations down requires special tax planning.
• Trust Income Tax (Post-Death): After you die, if a trust continues (for example, you left assets in a trust for your kids rather than outright), that trust will be subject to federal income tax on any income it earns each year. Trust tax rates reach the top bracket (37%) at very low levels of income (around $14,000), which is much faster than individual rates. To mitigate this, many trusts are designed to distribute income to the beneficiaries, so the income gets taxed at their presumably lower individual rates. This is a separate issue from inheritance or estate tax – it’s the ongoing income taxation of trusts. But it’s worth noting, since people sometimes ask “will I pay tax on money from a trust?” The answer: the inheritance itself no, but any later earnings yes.
• No Income Tax on Inheritance: To reiterate, if you simply receive an inheritance (say the trust pays you $50,000 from principal, or you inherit $50,000 outright from an estate), the IRS does not treat that as taxable income. You don’t report inherited cash or property (and inherited property gets that step-up in cost basis if it was included in the estate, meaning if you sell it immediately you likely owe no capital gains either). The only time income tax comes into play is on income generated by the inherited assets (interest, dividends, rental income, etc.) or if it’s a specific kind of account like a pre-tax retirement account which has its own rules.

In summary, federal tax law cares about the size of the estate and certain types of transfers. Trusts are a means to manage those transfers:

• If the trust is revocable or testamentary, it’s part of the taxable estate.
• If it’s irrevocable and properly executed, it can shift value out of the estate (using the gift exemption).
• There’s no federal inheritance tax to worry about, only the estate tax for large estates (and the GST for generation-skipping).
• After death, trusts pay income tax like any taxpayer unless distributed to beneficiaries.

Always keep an eye on the changing tax laws – the federal estate tax exemption is scheduled to drop roughly in half in 2026 (back to around $6–7 million per person) unless Congress acts. Trust strategies that aren’t needed for a $12 million estate might become very relevant for a $7 million estate if the law changes. Planning ahead with flexible trusts (or provisions that can create trusts at death depending on the law) can be wise.

State Inheritance Tax and Trusts: Navigating State Laws

Now let’s turn to state-level taxes. Even if you’re nowhere near the federal estate tax bracket, state taxes can surprise you. There are two types to watch: state estate taxes (similar to the federal estate tax but with lower exemptions) and state inheritance taxes (taxes on recipients of an inheritance). Our focus is on inheritance taxes, since the question is about “inheritance tax,” but we’ll mention estate taxes too for completeness.

• States with Inheritance Tax: As of 2024, six states impose an inheritance tax: Pennsylvania, New Jersey, Nebraska, Kentucky, Maryland, and Iowa. (Iowa’s tax is in the process of phasing out and will be fully gone by 2025.) If you live in one of these states, or the person leaving you money lived (or owned property) there, then inheritance tax might apply. The tax is based on the amount inherited and your relationship to the decedent. Each state’s rules differ:
  • In Pennsylvania, for example, spouses pay 0%, children and lineal descendants pay 4.5%, siblings pay 12%, and more distant heirs (friends, nieces/nephews) pay 15%. Charities are exempt.
  • In New Jersey, spouses, parents, and children are 0% (exempt), but siblings, sons/daughters-in-law, and other heirs can pay up to 11–16% on amounts over certain thresholds. (Grandchildren are exempt in NJ as “Class A” heirs, but a non-lineal heir can be taxed.)
  • Nebraska and Kentucky also have tiered inheritance tax rates depending on relationship, with closer relatives either exempt or at low rates and others up to 15–16%.
  • Maryland has a 10% inheritance tax on distant heirs, but exempts close relatives. Maryland uniquely also has a separate estate tax.
  • Iowa used to tax distant heirs up to 15%, but as noted, Iowa is eliminating its inheritance tax entirely.
• Who Pays: Inheritance tax is technically the responsibility of the beneficiary who receives the money. However, practically, it’s often the estate executor or the trustee who will file the necessary forms and ensure the tax is paid (sometimes out of the estate before distributing). But conceptually, it’s a tax on the transfer to that individual. If you’re inheriting through a trust, you might get a notice that you owe a certain amount of inheritance tax, or the trust may pay it on your behalf and deduct it from your share, depending on state law.
• Trust vs No Trust: If the assets pass via a trust (say a revocable living trust) rather than a will, it generally does not change the inheritance tax. States will still look at who the money ultimately went to and impose the tax accordingly. For example, if a $100,000 bank account is in a revocable trust and at the grantor’s death it goes to a friend, and the grantor was a resident of Nebraska, that friend would owe Nebraska inheritance tax (15% on amounts above the small exemption). The trust could pay it directly or the friend might have to pay it, but either way the tax must be paid. If that same $100,000 had been left by will to the friend, the tax would be the same. The trust just changes the mechanism of transfer, not the tax outcome.
• Can a Trust Avoid State Inheritance Tax? Generally, not if the transfer is essentially happening at death to a non-exempt beneficiary. However, as discussed in the irrevocable trust section, if you give assets to someone (or to an irrevocable trust for them) well before death, then it’s no longer an inheritance when you die, so inheritance tax wouldn’t apply. Some states have explicit rules to prevent deathbed workarounds. Pennsylvania, for instance, will still count gifts made within one year of death as part of the taxable estate for inheritance tax (to the extent over $3,000). But gifts made earlier than that are free of PA inheritance tax. So if a parent funded an irrevocable trust for a child two years before passing, Pennsylvania would not levy inheritance tax on that trust’s assets at the parent’s death – the child effectively already owned an interest via the trust.
• State Estate Taxes: Separate from inheritance taxes, 12 states plus D.C. have their own estate taxes, which hit the overall estate if above thresholds that are usually much lower than the federal limit. For example, Massachusetts taxes estates over just $1 million. States with estate taxes include New York, Massachusetts, Illinois, Oregon, Washington, Minnesota, Maryland, Hawaii, Vermont, Maine, Connecticut, and Rhode Island (and D.C.). If you live in one of these states, a revocable trust won’t avoid the state’s estate tax – if your total assets exceed the state exemption, the estate (including the trust assets) will owe state estate tax. However, an irrevocable trust can help here too: by removing assets from your estate, you might get under the state’s threshold. A common strategy for a married couple in a state estate tax state is to use credit shelter trusts to fully utilize each spouse’s lower exemption, similar to how one would plan for federal taxes.
• Example – New Jersey vs. Pennsylvania: Let’s say a person dies with a trust leaving $500,000 to a sibling. If the person was a New Jersey resident, what happens? New Jersey has no estate tax, but does tax inheritances to siblings (they are Class C beneficiaries) at rates up to 16% after a $25,000 exemption. So that sibling would owe some NJ inheritance tax (roughly $72,000 on a $500k inheritance). If that person instead lived in Pennsylvania, the sibling would owe PA inheritance tax at 12% (so $60,000 on $500k). If the person lived in a state with no inheritance tax (say, California), the sibling would inherit the $500k with no state “death tax” at all. In all cases, whether the money came via a trust or a will doesn’t change the calculation.
• Out-of-State Beneficiaries or Grantors: If you inherit from someone who lived in an inheritance-tax state, you may owe that state’s tax even if you live elsewhere. Conversely, if the decedent lived in a no-inheritance-tax state, it generally doesn’t matter where the heirs live – there’s no inheritance tax (states don’t tax people just for receiving money; they tax the transfer from the decedent who was under their jurisdiction). There can be complications if real estate or property is located in another state, but typically inheritance tax is based on the decedent’s state law.
• Planning for State Taxes with Trusts: If you’re in a state with these taxes and you have a sizable estate or plan to leave money to non-exempt people (like friends, nieces/nephews, etc.), consider:
  • Making gifts earlier (using trusts or direct gifts) to reduce what will pass at death.
  • If married, using trust strategies to maximize two exemptions (for state estate tax states).
  • Possibly changing your state of residency if the taxes are a big concern and you have flexibility – e.g., Florida and California have no estate or inheritance tax.
  • For inheritance tax specifically, you might structure bequests differently (for instance, leaving something to an in-law might trigger NJ inheritance tax whereas leaving to your child does not, so maybe leave more to the child).
  • Charitable gifts in your trust or will: leaving a portion to charity can reduce state tax because that portion may be exempt (most states don’t tax charitable bequests).

In conclusion, trusts won’t magically erase state inheritance taxes if your beneficiaries and state laws say tax is due. But strategic use of trusts can position assets to avoid being subject to those taxes (via lifetime transfers or out-of-state planning). Always examine both federal and your particular state’s rules – the optimal plan in a state like Pennsylvania (with inheritance tax) might differ from a plan in a state like New York (with estate tax) or Texas (with neither).

Below is a quick comparison table for a $200,000 inheritance under different state scenarios, to illustrate how location and relationship affect inheritance tax:

As you can see, in Pennsylvania the tax depends on who the beneficiary is – a child faces a much smaller tax than a friend. In California, neither would owe anything. Whether that $200k was left via a trust or by will wouldn’t change the outcome; it’s the state’s law that matters.

Real-World Scenarios: How Trusts Impact Tax Outcomes

To tie everything together, let’s walk through a few common real-world scenarios involving trusts and potential taxes. These examples illustrate when a trust does or doesn’t make a difference in the tax bill.

Scenario 1: Revocable Trust vs. Will – Does It Change Taxes?

Situation: Jane, a resident of Pennsylvania, has $1 million in assets. She wants to leave it all to her two children. She’s considering putting her assets in a revocable living trust to make things easier.

• Without a trust, if Jane simply writes a will, her estate of $1 million will go through probate, then be distributed to her kids. Pennsylvania will levy a 4.5% inheritance tax on transfers to children.
• With a revocable living trust, when Jane dies, the trust assets go directly to her kids without probate.

Tax outcome: Either way, Pennsylvania inheritance tax applies at 4.5% for lineal heirs. The trust does not avoid that $1,000,000 × 4.5% = $45,000 tax (which the executor or trustee would ensure is paid, likely out of the estate or trust funds, before the kids get the net amount). For federal estate tax, Jane’s $1 million estate is well below the $12.92 million exemption, so no federal estate tax in either scenario.

Other outcomes: The revocable trust saves the kids the hassle of probate, potentially gets them their inheritance faster, and keeps the details private. But from a pure tax perspective, Jane’s estate will owe the same $45,000 PA tax whether or not a trust is used.

Takeaway: A revocable trust is great for convenience and probate avoidance, but it won’t save inheritance tax in a state like PA. Jane would need different strategies (like gifting during life or insurance planning) to reduce that tax.

Scenario 2: Using an Irrevocable Trust to Reduce Estate Tax

Situation: Robert has a net worth of $20 million. No state inheritance tax in his state, but he’s concerned about federal estate tax. If he does nothing, at death anything over the exemption (~$13 million) would face a 40% tax. That could be roughly ($20M – $13M) = $7M taxable, $2.8M in tax. His heirs would net about $17.2M.

Robert decides to take action. While alive, he gifts $8 million of assets into an irrevocable trust for his children and grandchildren. He uses $8M of his lifetime gift exemption to cover this transfer (so no gift tax owed). He retains no control over those assets now.

Tax outcome: When Robert later dies:

• The $8M in the irrevocable trust is not in his estate (and may have grown outside his estate too). Suppose it grew to $10M by his death – that growth also escapes estate tax.
• Robert’s remaining estate is $12 million (his original $20M minus the $8M gift). If the estate tax exemption at death is still around $13M, his estate owes no federal estate tax at all.
• Result: His heirs get the $10M from the trust (estate-tax free) plus the $12M estate, totaling $22M – and no estate tax was paid.
• If he had not used the trust, his heirs would have gotten about $17.2M after a possible $2.8M tax. The irrevocable trust strategy potentially saved his family millions in federal tax.

Trade-offs: By giving away $8M early, Robert parted with those assets and any flexibility with them. Also, those assets won’t get a step-up in basis at Robert’s death. If the $8M had a cost basis of $5M, and grew to $10M, the trust carries that $5M basis. If the kids sell assets, they might owe capital gains on the $5M gain. Had Robert kept them until death, that $10M would have a new basis of $10M (no capital gains if sold then). The family avoided estate tax but may incur some capital gains tax down the road – typically much smaller than a 40% estate tax, but a consideration nonetheless.

State considerations: If Robert lived in a state with an estate tax or his $20M included property in an inheritance-tax state, the irrevocable trust would also help mitigate those taxes similarly (by reducing what passes at death). But watch out for any state rules (e.g., some states might count certain gifts if within a few years of death).

Takeaway: An irrevocable trust can significantly cut estate taxes for a wealthy individual. It requires using some of your lifetime exemption and giving up control of the assets, but it can save millions for your heirs if your estate would otherwise be taxable.

Scenario 3: Inheritance Tax Differences by State and Relationship

Situation: Two friends, Alice and Barbara, each receive $100,000 as beneficiaries of a trust after the grantor (a friend of theirs) dies. The only difference is the state involved:

• Alice’s friend was a resident of Pennsylvania (inheritance tax state).
• Barbara’s friend was a resident of California (no inheritance tax state).

Additionally, consider two family members in Pennsylvania:

• Charlie inherits $100,000 from his parent’s revocable trust in PA.
• David inherits $100,000 from his aunt’s trust in PA.

Tax outcome:

• Alice, inheriting as a friend in PA, owes Pennsylvania inheritance tax at the 15% rate for unrelated beneficiaries. She will pay $15,000 (or have that amount withheld from the trust distribution).
• Barbara, inheriting the same amount as a friend in California, owes $0 state tax.
• Charlie, a son inheriting in PA, owes 4.5% inheritance tax on $100,000, which is $4,500.
• David, a nephew inheriting in PA, would owe 15% as well (Pennsylvania taxes a nephew as an “other heir” at the highest rate), so $15,000 on $100k.

The trust itself in each case doesn’t pay; it’s the recipients who are taxed according to state law.

We can summarize some outcomes in a table:

Takeaway: The location and relationship make all the difference. In Pennsylvania, a friend or distant relative can lose a hefty chunk to inheritance tax, whereas in California the same inheritance is tax-free. The trust didn’t change these outcomes – a trust or will distribution would face the same state tax rules. To minimize such taxes, one must plan by changing the timing of transfers (gifting during life) or the state of residence, or by taking advantage of exemptions (e.g. leaving more to exempt relatives or charity).

Common Mistakes to Avoid in Trust and Tax Planning

Setting up trusts and planning for taxes can be complex. Here are some common mistakes people make, and how to avoid them:

• Assuming a Living Trust Cuts Taxes: Simply creating a revocable living trust does not reduce estate or inheritance taxes. Don’t equate “avoiding probate” with “avoiding tax.” Estate tax planning often requires irrevocable trusts or other techniques, not just a basic living trust.
• Waiting Too Long to Plan: Last-minute transfers or creating a trust on your deathbed may fail to avoid taxes. Many tax-saving strategies (like gifting to a trust) need to be done years in advance to work effectively.
• Retaining Too Much Control: If you try to use an “irrevocable” trust but keep strings attached (like control or benefit from the assets), the IRS can still treat those assets as yours and tax them. Truly give up ownership to get the tax benefits.
• Ignoring State Taxes: Don’t overlook your state’s estate or inheritance taxes. It’s a mistake to plan for federal tax and assume you’re in the clear. For example, you might dodge federal tax but still owe a hefty state tax if your state has a low exemption or an inheritance tax.
• Not Using Both Spouses’ Exemptions: Married couples sometimes fail to use the first spouse’s estate tax exemption. This mistake can cost millions in taxes. Consider strategies like a bypass trust or portability election so each spouse’s exemption shelters assets.
• Overlooking Basis Step-Up: Be careful when removing assets from your estate. Gifting highly appreciated assets to a trust can save estate tax but loses the step-up in basis at death. Heirs might pay more in capital gains later. Balance your plan to minimize overall taxes, not just estate tax.
• Naming a Trust as IRA Beneficiary without Planning: If you name a trust as beneficiary of a retirement account without proper planning, it can trigger faster payouts (and taxes) than if an individual inherited it. Use see-through trust provisions or other specialized planning for retirement accounts to avoid this costly mistake.
• Failing to Fund or Update the Trust: A common error is signing a great trust but never transferring assets into it (funding it). An unfunded trust won’t accomplish your goals. Similarly, not updating your trust when laws or life circumstances change can lead to missed opportunities or unintended taxes.
• No Professional Advice: Trying to navigate complex trust and tax strategies without expert help is risky. Tax laws have nuances and change frequently. A mistake or oversight could negate your tax savings or cause legal issues. It’s worth consulting an estate planning attorney or tax professional to get it right.

FAQs

Do trusts avoid inheritance tax? No. A revocable living trust won’t avoid inheritance or estate taxes; it only avoids probate. Only certain irrevocable trust moves might bypass those taxes, and only if set up properly well before death.

Is there a federal inheritance tax? No. There is no federal inheritance tax in the United States. The IRS only imposes a federal estate tax on very large estates above the exemption amount.

Do any states have inheritance tax? Yes. Six states (PA, NJ, NE, MD, KY, IA) levy inheritance taxes. In those states, what you pay depends on how closely related you are to the deceased and how much you inherit.

Can a trust reduce estate tax? Yes. An irrevocable trust can remove assets from your taxable estate. By gifting assets into such a trust (using your lifetime exemption), you can reduce or even eliminate estate tax on those assets.

Does a revocable living trust avoid estate tax? No. Assets in a revocable trust count as part of your estate at death. If your estate exceeds the exemption, those trust assets get taxed just like assets outside the trust.

Is inheritance from a trust taxable as income? No. Inherited money or property isn’t counted as income on your federal tax return. You don’t pay income tax on a pure inheritance.

Do beneficiaries pay taxes on trust distributions? Yes, sometimes. Beneficiaries must pay income tax on trust earnings distributed to them, but not on the principal they inherit. State inheritance tax could also apply, depending on the state.