250 years ago, our country declared independence from Great Britain in no small part due to unfair taxes. Two and a half centuries later, Americans are still looking for ways to pay less taxes. In fact, one of the most common questions we get as estate planning attorneys is how to reduce taxes with estate planning.

Estate planning intersects with multiple types of taxes, and there are many strategies, sometimes conflicting strategies, to reduce taxes. Below are five types of taxes to consider when estate planning:

1. Estate Taxes

An estate tax is a one-time tax due at someone’s death based on the value of the deceased person’s assets at death. The federal estate tax is only applicable when a person dies with more than $15 million (2026 amount) in their estate. However, the Massachusetts estate tax kicks in when a person dies with $2 million in their estate, which can very easily happen in Massachusetts if a person owns real estate.

Assets passing outside of probate, such as retirement accounts with beneficiaries, investment accounts held in a revocable trust, and life insurance are all countable assets when calculating estate tax. This means that estate planning tools for avoiding probate do not automatically reduce estate tax liability.

There are a few options to reduce estate taxes at your death. Married couples can utilize credit shelter trusts to make sure that both of their $2 million estate tax exemptions are used. People can also give away assets before their death, perhaps to their children or to irrevocable trusts to lower their taxable estate. The best approach will largely depend on your asset structure and family situation, and you should discuss your options with your estate planning attorney.

A similar concept to an estate tax is an inheritance tax, which is a tax the beneficiaries have to pay as they receive money instead of a tax the estate has to pay before assets pass to the beneficiaries. A few states have inheritance taxes, but Massachusetts does not. There is also no federal inheritance tax.  

2. Income Taxes

Income taxes become relevant to estate planning whenever there are pre-tax retirement accounts such as traditional IRAs, 401(k)s, and 403(b)s. Distributions from these accounts are taxed as income to you (or whoever the beneficiary is). Because income taxes are taxed using progressive brackets, it is usually preferable for pre-tax retirement accounts to take out smaller distributions over a longer period of time as opposed to taking larger distributions over a shorter period of time. 

The federal government has a lot of rules around beneficiaries taking out required distributions from retirement accounts and the period of time a beneficiary has to take out distributions. The period of time can vary widely from 5 years to the rest of the beneficiary’s life. Depending on your retirement assets, the intended beneficiaries for said assets (including whether there is any charitable giving as part of your estate plan), your marital status, and use of trust instruments as part of your plan, your estate planning attorney can advise you on the best way to minimize income taxes due while achieving your estate plan goals. 

3. Capital Gains Taxes

Capital gains taxes are a subtype of income taxes imposed upon the increase in value of an asset. A tax is only due when an asset is sold, and the tax is calculated against the amount of capital gain (the present value of the asset less the tax basis). The classic two examples of capital gains taxes are on houses and stocks. If you buy your home for $150,000, and then later sell it for $200,000, there is a capital gain of $50,000.

There are a couple of laws in place which help reduce capital gains tax liability. First, there is a $250,000 capital gains exclusion ($500,000 for a married couple) for the sale of your primary residence. This means that $250,000/$500,000 is deducted from your capital gains before a tax is calculated. 

The second law concerns “stepped-up basis”. When an asset like a house is gifted to someone, the house retains the tax basis of the person who made the gift. However, when a house is inherited, the house’s tax basis becomes the value of the house at the deceased person’s death (it gets a “stepped-up” basis). For example, if person A buy a house for $100,000, gifts the house to person B when it is worth $150,000, and B later sells the house for $175,000, the capital gain is $75,000 ($175,000 – $100,000). If, instead, person A buys a house for $100,000, dies when the house is worth $150,000 leaving it to person B, and B later sells the house for $175,000, the capital gain is just $25,000 ($175,000 – $150,000).  

The takeaway lesson is that it often makes sense to hold onto property until your death rather than giving it away. This can affect what type of estate planning documents and provisions are necessary. 

4. Gift Taxes

Gift taxes are an often-misunderstood type of tax. There is no Massachusetts gift tax, but there is a federal gift tax, which is tied to the federal estate tax. As mentioned above, every person has a $15 million exemption (2026 amount) before they need to pay any estate taxes. However, if a person makes large gifts throughout their lifetime, that $15 million exclusion is reduced by the amount of the gift. For instance, if person C made a gift of $1 million to her child, her lifetime federal estate tax exemption would be reduced from $15 million to $14 million. 

The federal government does not want to track every small gift you make, so you only need to file a gift tax return when you make a gift of over $19,000 per recipient (2026 amount). If a gift of over $19,000 to a single person was made during a year, no tax will be due (unless you’ve exhausted the $15 million amount). The gift of over $19,000 simply triggers a need to file the gift tax return. 

Gifting is frequently part of a comprehensive estate plan strategy to reduce your estate for estate tax purposes. For most people, this will result in more tax paperwork but not an increase in taxes. 

5. Generation Skipping Transfer Taxes

Families with large amounts of assets may not just be worried about their estate tax liability but the estate tax liability of their children. The fear is that a federal-estate-tax taxable inheritance left to your child will make your child wealthy enough that their estate also has a federal estate tax. This could be viewed as a double hit of estate tax on the same wealth.

A strategy around this would be to leave some of your assets to your grandchildren instead of it all to your children. That way, your children’s estates will be reduced at their death for estate tax purposes. The federal government, however, curbs this strategy somewhat with the generation-skipping transfer tax. (There is no Massachusetts generation skipping transfer tax.) The generation-skipping transfer tax imposes a tax on any transfer from you to someone 37.5 years younger than you (excluding children and children of deceased children). However, like the federal estate tax, there is a $15 million lifetime exclusion amount. This $15 million exclusion is separate from the combined $15 million federal estate/gift tax exclusion. 

Most clients will not need to worry about generation skipping transfer tax, but it is important to know what it is and why language for it often appears in trusts. 

When drafting your estate plan, it’s important for you to let your estate planning attorney know your tax concerns so they help create a plan that best meets your needs.

Attorney Sean Downing is a senior attorney with the Dedham firm of Samuel, Sayward & Baler LLC, which focuses on advising its clients in the areas of Trust and estate planning, estate settlement, and elder law matters. This article is not intended to provide legal advice or create or imply an attorney-client relationship. No information contained herein is a substitute for a personal consultation with an attorney. For more information visit ssbllc.com or call 781-461-1020.

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