While estate taxes and exemptions often grab the headlines, income taxes within an estate plan are often just as critical. Smart income tax planning can mean the difference between preserving wealth for your heirs or leaving them with an avoidable tax bill. To maximize what your heirs actually keep, you need to consider both sides of the equation: estate taxes and income taxes. In this article, we highlight three key areas where income tax considerations intersect with estate planning.
1. Gifting vs. inheriting assets: Carryover basis vs. step-up in basis
One of the most pivotal decisions in estate planning for wealthy families is whether to gift assets during your lifetime or hold them until death. The timing of a transfer can drastically affect the tax bill your loved ones will face. The core issue is how tax basis is handled in various scenarios, which in turn determines capital gains taxes due when the asset is sold.
- Carryover basis for lifetime gifts: If you gift an asset (like marketable securities or real estate) to your children during your life, they generally receive it with your original basis (what you paid for it). This is called a carryover basis. If they later sell the asset, they may owe capital gains tax on the appreciation that occurred while you owned the asset, taxed at their rate. For example, if you bought stock for $100,000, and it’s worth $300,000 now, gifting it means your child’s basis is $100,000. If they sell it for $300,000, they’d incur tax on the $200,000 gain.
- Step-up in basis at death: In contrast, assets passed through your estate at death get a “step-up” in basis to their current market value. Using the same example, if you held that $300,000 stock until your death, your heirs’ tax basis would “step up” to $300,000 (the value at your death), wiping out the $200,000 of taxable gain. If they sell the stock at $300,000, no capital gains tax is due.
For tax planning, many times the decision to gift an asset depends on whether your estate will be subject to estate tax (federal, state, or both), and the potential appreciation of that asset over your expected lifetime. By gifting assets now, you remove future appreciation from the estate, potentially saving 40% federal estate tax on that growth but losing the step-up in basis. Given that the current federal estate tax rate is significantly higher than the capital gains tax rate, the estate tax savings may outweigh the lost basis step-up.
The best course of action is situation-dependent, and the potential estate tax savings should be analyzed in conjunction with the impact to the income taxes for the family. If you’re not subject to estate tax, you may preserve more wealth by holding appreciated assets until death for the step-up. However, there may be good reasons to make gifts — such as helping a child purchase a home or providing support for education, business ventures, or other significant life events — but the structuring of those gifts should be intentional because they could have a significant impact on income and estate tax planning for the family.
2. Review and refresh your estate planning documents
Because tax laws change, it’s critical to periodically review your will, revocable trusts, and overall estate plan. If it’s been years since your estate planning documents were reviewed and updated, they might contain provisions designed for a very different tax environment. Going back only a decade to 2016, the federal estate tax exemption has gone from $5.45 million per person ($10.90 million for married couple) to $15 million per person ($30 million for a married couple) in 2026.
There are many critical items in estate plans that are based off the exemption, so if you haven’t reviewed them regularly, you could be faced with unintended results and bad tax outcomes. Two areas to watch for are a missed second step-up in basis for spouses and considering the tax profile of beneficiaries.
Missed second step-up in basis for spouses
Many estate plans for married couples use a “credit shelter trust” to save estate tax. When the first spouse dies, a portion of the estate equal to the remaining federal estate tax exemption goes into a trust for the surviving spouse, with the rest passing to the survivor outright or to a marital trust. The credit shelter trust is excluded from the surviving spouse’s later estate, potentially reducing estate tax if the combined estate exceeds the exemption. However, if the combined estate won’t be large enough to owe federal estate tax — now a possibility for some estates due to the increased exemption amounts — the credit shelter trust may do more tax harm than good.
It’s not helpful to plan for estate taxes if none will be incurred because it comes at a cost of a lost second basis step-up when the surviving spouse passes away. If the credit shelter trust assets appreciate in value during the life of the surviving spouse, your heirs would receive the assets with avoidable capital gains if those assets would have been includable in the surviving spouse’s estate. Having a good understanding of your personal balance sheet, including asset titling and values, is a necessity to understand how to appropriately tax plan.
Overlooking beneficiaries’ tax situations
Another common blind spot is failing to account for the tax profile and location of the people or trusts that will ultimately receive your assets. If the proper design isn’t in place, future generations may end up paying more in income tax year after year or unnecessarily miss out on basis step-ups when a beneficiary passes away.
With irrevocable trusts, state income tax exposure can hinge on a surprisingly fluid set of factors. For example, the state where a trust became irrevocable, the residency of its beneficiaries, the location of the trustee, and even where trust administration occurs can all create or eliminate a state’s ability to tax a trust. In high income tax states, a poor structure may allow the state to impose a 10% plus state income tax on earnings annually that could potentially be avoided. Without careful planning, seemingly innocent changes — such as a trustee or beneficiary relocating — can inadvertently shift an otherwise income tax‑efficient trust to be subject to a higher state income tax rate.
In some cases, the net worth is broken up over several individuals, and those beneficiaries aren’t subject to estate tax even if the parent was. And sometimes, beneficiaries receive assets in trust that aren’t included in the beneficiary’s taxable estate. In many cases, it can be advantageous to pull more assets into the beneficiary’s taxable estate to allow for a basis step-up to occur before the trust assets pass to the beneficiary’s descendants. But this requires careful drafting to account for the potential that the beneficiary will be subject to federal or state estate taxes.
While not income tax-related, changes to estate tax exemptions can also impact other parts of the estate plan causing unintended results. If you have gifts in your estate plan that are tied to the estate tax or generation-skipping transfer tax exemption, those formulas and gifts should be reviewed to ensure that the dollar amounts going to the various beneficiaries are still achieving your goals. Also, if you reside in a state with an estate tax, care must be taken with formulas that automatically direct the full federal exemption amount to a certain type of trust, or you may unnecessarily trigger estate tax on the first spouse’s passing. Also, note that state estate taxes can apply to out-of-state residents who own in-state property, such as a Florida resident who owns a vacation home in Illinois or Massachusetts.
3. Assigning the right assets to the right beneficiaries
An often overlooked yet critical strategy for families is aligning which assets go to which beneficiaries in order to minimize taxes. A sophisticated estate plan doesn’t just divide the wealth — it matches asset types to the right heirs or organizations to maximize the after-tax value received. Different types of assets are taxed differently when inherited, so who gets what can make a big difference. Assets like traditional IRAs and 401(k) plans are loaded with deferred income taxes, and most heirs (other than your spouse) must withdraw those funds within 10 years, potentially paying hefty income taxes on every dollar withdrawn. However, qualified charities, including a donor-advised fund, pay no income tax on these donations. By designating a charity as the beneficiary of your IRA or other pretax retirement account, 100% of that account can go to a good cause. Meanwhile, you can leave more tax-favored assets that receive a basis step-up to your family members, maximizing the net value they receive.
Strengthening your legacy through coordinated tax planning
It’s not just what you leave your loved ones — it’s how you leave it. Thoughtful planning that integrates both estate tax and income tax considerations ensures more of your hard‑earned wealth goes to the people and causes you care about, not to taxes. Because tax rules are complex and continually evolving, it’s essential to review your plan regularly with a knowledgeable advisor. With the right guidance, you can protect and optimize your legacy, giving you and your family confidence and peace of mind for generations to come.
