Wills, Trusts and the Tax Rules Governing Them

Fewer than half of American adults have a will, yet nearly everyone will eventually leave behind an estate of some kind. Whether your assets are modest or substantial, the decisions you make, or fail to make, about wills and trusts can have lasting financial and personal consequences for the people you leave behind. This article explains how each instrument works, how they are taxed under 2025 federal rules, and what you should discuss with your CPA or estate-planning attorney.

PART I: WILLS AND TRUSTS: THE FUNDAMENTALS

What Is a Will?

A will (formally, a "last will and testament") is a legal document that takes effect at your death and directs how your probate assets are distributed. Without one, your state's intestacy laws, not your wishes, determine who receives your property, who raises your minor children, and who administers your estate. The results can be costly, time-consuming, and deeply unsatisfying for the people you care about most.

Key Features of a Will

• Designate beneficiaries: You specify exactly who receives what: family members, friends, charities, or other organizations.

• Name an executor: This person (or institution) is responsible for gathering assets, paying debts and taxes, and distributing the remainder to beneficiaries. Always discuss this role with your chosen executor before naming them.

• Appoint a guardian for minor children: If you have children under 18, a will is the primary vehicle for naming who will care for them. Without this designation, a court will make that decision for you.

• Create testamentary trusts: A will can establish a trust that springs into existence at your death, allowing assets to be managed and distributed over time rather than in a lump sum.

• Override intestacy for non-heirs: Wills are the only way to include unmarried partners, stepchildren, friends, charities, or in-laws who would not inherit under your state's default rules.

Execution Requirements

To be legally valid, a will must be signed by you (the testator) and witnessed by two or three adults, the number depends on your state. Some states also require notarization. Keep your will in a secure, accessible location and inform your executor and a trusted family member where it is stored.

Keep Your Will Current

A will that reflects yesterday's circumstances can cause tomorrow's problems. Review and update your will after major life events, including marriage or divorce, the birth or adoption of a child, the death of a named beneficiary or executor, a significant change in your assets, or a move to a different state.

What Is a Trust?

A trust is a legal arrangement in which one party (the grantor) transfers ownership of assets to a trustee, who holds and manages those assets for the benefit of one or more beneficiaries. Unlike a will, a trust can operate during your lifetime and continue seamlessly after your death, without going through probate.

Types of Beneficiaries

Trusts typically have two classes of beneficiaries:

• Income beneficiaries receive the earnings generated by trust assets (dividends, interest, rent, etc.) during the life of the trust.

• Remainder beneficiaries receive the trust's principal when the trust terminates.

What Can a Trust Hold?

Almost any asset can be placed in a trust: cash, brokerage accounts, real estate, business interests, life insurance proceeds, and more. The trustee, which can be a bank, trust company, attorney, CPA, or trusted individual, manages these assets according to the terms you set.

Common Trust Structures

• Revocable living trust: Created during your lifetime and fully modifiable. Useful for avoiding probate and providing seamless asset management if you become incapacitated. Does not reduce estate taxes.

• Irrevocable trust: Once established, the terms generally cannot be changed. Assets transferred into an irrevocable trust are typically removed from your taxable estate, which can reduce estate tax exposure for high-net-worth individuals.

• Testamentary trust: Created inside a will and takes effect at death. Subject to probate but allows detailed control over how and when assets pass to beneficiaries.

• Generation-skipping trust (GST): Allows assets to pass to grandchildren or later generations, potentially bypassing a layer of estate tax.

• Qualified Terminable Interest Property (QTIP) trust: Provides income to a surviving spouse during his or her lifetime, with the remainder passing to children at the surviving spouse's death.

• Special needs trust: Holds assets for a disabled beneficiary without disqualifying them from government benefits programs.

• Credit shelter trust (bypass trust): Used by married couples to ensure both spouses' estate tax exemptions are fully utilized, potentially sheltering significantly more from federal estate tax.

Trusts vs. Wills: Critical Distinctions

One point that catches many families by surprise: a will only governs probate assets; those held in your name alone with no beneficiary designation. Jointly owned property, retirement accounts (IRAs, 401(k)s), and life insurance policies with named beneficiaries all pass outside the will entirely, directly to the surviving joint owner or named beneficiary. A comprehensive estate plan addresses both probate and non-probate assets.

Planning Tip: Trusts generally avoid probate, giving beneficiaries quicker access to assets and preserving privacy (wills become public record after probate). However, trusts carry higher upfront setup costs than wills. For many families, the right answer is a combination of both. Your CPA and estate-planning attorney can help you determine which approach fits your specific circumstances.

PART II: THE TAX LANDSCAPE FOR ESTATES AND TRUSTS

Federal Estate Tax

Not every estate owes federal estate tax, in fact, the vast majority do not. For 2025, the federal estate and gift tax exemption is $13.99 million per individual ($27.98 million for married couples using portability). The top federal estate tax rate is 40% on amounts exceeding the exemption.

The gross estate includes all property owned at death plus post-1976 taxable gifts. From this, the estate may deduct funeral expenses, administrative expenses, outstanding debts, and state death taxes. Property passing to a surviving U.S.-citizen spouse or to a qualified charity is generally fully deductible under the unlimited marital and charitable deductions.

Note: Portability allows a surviving spouse to "inherit" the deceased spouse's unused exemption, effectively doubling the couple's combined shelter. However, portability must be elected on a timely filed estate tax return (Form 706), it is not automatic. Families near or above the exemption threshold should plan proactively.

State-Level Estate and Inheritance Taxes

Federal exemptions tell only part of the story. Twelve states and the District of Columbia impose their own estate taxes, often with far lower exemptions: Oregon and Rhode Island, for example, begin taxing estates at $1 million. Additionally, as of 2025, five states: Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania, impose an inheritance tax levied on the beneficiary receiving assets (not on the estate itself). Maryland is the only state with both an estate tax and an inheritance tax.

In most states, close relatives (spouses, children) are exempt from inheritance tax or subject to lower rates. The relationship between the beneficiary and the decedent determines the rate. If you own property in multiple states, each state's rules may apply to the assets located there.

Income Taxation of Estates and Trusts (Form 1041)

When a person dies, their estate becomes a separate taxable entity. Income generated between the date of death and the final distribution of assets to beneficiaries must be reported to the IRS on Form 1041, U.S. Income Tax Return for Estates and Trusts. Trusts are similarly required to file. The personal representative or trustee is responsible for filing using the entity's own Employer Identification Number (EIN).

When Must Form 1041 Be Filed?

An estate must file Form 1041 if it has gross income of $600 or more during the tax year, has a beneficiary who is a nonresident alien, or holds a qualified investment in a Qualified Opportunity Fund (QOF) at any time during the year. Trusts must file if they have any taxable income, regardless of amount. For calendar-year 2025 returns, Form 1041 is due April 15, 2026. An automatic 5.5-month extension is available by filing Form 7004.

2025 Income Tax Brackets for Estates and Trusts

One of the most important, and often misunderstood, aspects of estate and trust taxation is how quickly income climbs through the tax brackets. Congress applies the same graduated rate structure used for individuals but compressed into a far narrower income range. The 2025 brackets are:

By comparison, an individual taxpayer does not reach the 37% bracket until taxable income exceeds $626,350 (single) or $751,600 (married filing jointly) in 2025. This compression makes income distribution planning critical: income distributed to beneficiaries is generally taxed at their individual rates, which may be substantially lower.

Capital Gains Rates

Capital gains recognized inside an estate or trust are subject to preferential rates, but again at compressed thresholds. For 2025, the 0% rate applies to gains up to $3,250; the 15% rate applies from $3,251 to $15,900; and the 20% rate applies above $15,900.

Net Investment Income Tax (NIIT)

Estates and trusts that retain investment income may also be subject to the 3.8% Net Investment Income Tax. For 2025, the NIIT applies to the lesser of undistributed net investment income or the amount by which adjusted gross income exceeds $15,650. Estimated tax payments and underpayment penalties apply to NIIT as well.

Exemptions

The following exemptions reduce taxable income for purposes of Form 1041:

• Estates: $600 exemption

• Simple trusts (required to distribute all income currently): $300 exemption

• Qualified disability trusts: $5,100 exemption

• All other trusts: $100 exemption

Estimated Tax Obligations

Estates are generally exempt from estimated tax payments for the first two tax years following the decedent's death; a welcome administrative relief for newly appointed executors. Trusts, however, must generally make estimated payments beginning in their first tax year. Exceptions exist for certain grantor and charitable trusts.

Deductions Available to Estates and Trusts

Reducing taxable income through allowable deductions is one of the most effective tools available to fiduciaries. The following expenses are generally deductible on Form 1041:

• Fiduciary fees paid for administering the estate or trust, including probate court fees and costs, bond premiums, legal publication costs (e.g., notices to creditors), the cost of certified death certificates, and fiduciary accounting costs.

• Professional fees for preparing Form 1041, the decedent's final Form 1040, and estate and generation-skipping transfer tax returns (Form 706).

• Business and rental income and losses reported on Schedule C or Schedule E, as applicable, are netted and carried to Form 1041.

Fees for preparing gift tax returns (Form 709) are not deductible on Form 1041. Additionally, when advisory fees are bundled together, they must be allocated between deductible fiduciary expenses and nondeductible investment advisory costs.

The Step-Up in Basis

One of the most significant tax benefits associated with inherited property is the stepped-up (or stepped-down) basis rule. When a beneficiary inherits an asset, its tax basis is adjusted to the fair market value at the date of the decedent's death. This means that if a beneficiary later sells the asset, only the appreciation after the date of death is subject to capital gains tax; years or decades of pre-death appreciation effectively escape income tax entirely.

Additionally, inherited assets are automatically treated as long-term capital gains property, regardless of how long the decedent or beneficiary actually held the asset.

One exception: a loss on the sale of a decedent's residence is not deductible if a beneficiary uses the home for personal purposes after inheriting it.

Example: A decedent purchased stock for $20,000 that was worth $200,000 at death. A beneficiary who inherits and immediately sells that stock pays capital gains tax only on appreciation after the date of death; the $180,000 of pre-death gain is permanently excluded from income tax. This makes the stepped-up basis one of the most powerful wealth-transfer features in the tax code.

Rental Real Estate and Other Business Income

If an estate or trust operates rental property, income and expenses are reported on Schedule E and the net result flows to Form 1041. A special rule provides that for tax years ending before the second anniversary of the decedent's death, the estate may deduct up to $25,000 of rental real estate losses against nonpassive income; provided the decedent actively participated in the activity before death.

Similarly, if the estate operates a business or farm, income and expenses are reported on Schedule C or Schedule F, with the net figure carried to Form 1041.

PART III: PRACTICAL PLANNING CONSIDERATIONS

Married Couples: Maximizing Both Exemptions

Without planning, a married couple can inadvertently waste one spouse's estate tax exemption. If the first spouse to die leaves everything to the survivor, the deceased spouse's exemption may go unused (or must be claimed via the portability election). A credit shelter trust (also called a bypass trust) is a traditional technique that funds a separate trust with the first spouse's exemption amount, ensuring both exemptions shelter assets from estate tax. Although portability has simplified planning for many families, irrevocable credit shelter trusts still offer advantages, particularly for state estate tax planning and asset protection, that portability does not.

The Income Distribution Decision

Because trusts reach the top 37% income tax bracket at just $15,651 of taxable income, trustees face a meaningful planning decision each year: retain income inside the trust or distribute it to beneficiaries? Income distributed to beneficiaries is taxed at their individual rates, which in many cases will be lower. Distributable net income (DNI) establishes the ceiling for the distribution deduction available to the trust. Proper coordination between the fiduciary and the beneficiaries' tax advisors can produce significant overall tax savings.

Annual Gift Tax Exclusion

Reducing the size of a taxable estate begins during life, not at death. For 2025, each individual may give up to $19,000 per recipient per year completely free of gift tax, without using any portion of the lifetime exemption. A married couple can combine their exclusions, gifting up to $38,000 per recipient annually. Systematic gifting over time can meaningfully reduce estate size while transferring wealth to the next generation.

Bottom Line: Estate and trust taxation sits at the intersection of income tax, transfer tax, and state law — making it one of the most complex and high-stakes areas of personal finance. The stakes are too high for a do-it-yourself approach. Your CPA can help you identify whether your current plan is still aligned with current law, model the income tax impact of trust distribution strategies, and coordinate with your estate-planning attorney to ensure every document: will, trust, beneficiary designation, and title, works together as intended.

PART IV: CALIFORNIA-SPECIFIC CONSIDERATIONS

The Good News: No California Estate or Inheritance Tax

California does not impose a state-level estate tax or inheritance tax. For decedents who died on or after January 1, 2005, there is no requirement to file a California Estate Tax Return. This places California among the majority of states that have eliminated their own death taxes. As a result, for most California families, the only estate tax exposure is at the federal level, and as discussed in Part II, the federal exemption is $13.99 million per individual in 2025, shielding the vast majority of estates from federal estate tax entirely.

California also does not impose a state-level gift tax. Only federal gift tax rules apply, meaning the $19,000 annual exclusion per recipient and the $13.99 million lifetime exemption govern transfers made by California residents.

Important caveat: If you own real property located in another state that does impose an estate or inheritance tax, such as Oregon, which begins taxing estates at $1 million, or Massachusetts, those states may tax the assets situated within their borders, regardless of where you live. Similarly, if you are a California resident who inherits from a decedent in one of the five states that impose inheritance taxes (Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania), you may owe that state's inheritance tax depending on the applicable rules and your relationship to the decedent.

Proposition 19 and Property Tax Reassessment

For most California families, the most significant estate planning tax issue is not estate tax, it is Proposition 19 and its impact on property tax reassessment. Understanding this law is essential for anyone who owns California real estate and expects to transfer it to the next generation.

California's Proposition 13 (1978) caps annual property tax increases at 2% per year for as long as the same owner holds the property. This means longtime owners often pay property taxes based on an assessed value that is a fraction of current market value. When property is transferred, however, it is generally reassessed to full current market value, which can dramatically increase the annual property tax burden for the new owner.

Proposition 19 (effective February 2021) significantly narrowed the parent-to-child exclusion from reassessment that had existed under prior law. Here is what changed:

Before Proposition 19: Parents could transfer their primary residence and up to $1 million in other real property to their children without triggering a reassessment. Children could use inherited property however they wished: rent it out, use it as a vacation home, or hold it as an investment, and still preserve the low tax base.

After Proposition 19: The exclusion from reassessment now applies only if the inheriting child makes the transferred property their primary residence within one year of the transfer. Even then, the exclusion is only partial. As of February 16, 2025, the reassessment exclusion amount, adjusted for inflation, is $1,044,586. This means that if the property's fair market value at transfer exceeds the parent's assessed value by more than $1,044,586, the child's new assessed value is set at fair market value minus $1,044,586. For high-value California real estate, this can still result in a significant property tax increase. This exclusion amount is recalibrated every two years based on the California Consumer Price Index.

Rental properties, vacation homes, commercial real estate, and other investment properties no longer qualify for any parent-to-child exclusion. These properties are fully reassessed to current market value upon inheritance. In many California markets, particularly in the Bay Area and Southern California, where property values have appreciated dramatically, this reassessment can mean tens of thousands of additional property tax dollars per year.

Scenario: Family Home in Los Angeles: A parent purchased a home in Los Angeles in 1990 for $300,000. It is now worth $1,800,000, but due to Proposition 13 protections, the assessed value is only $500,000 and the annual property tax is approximately $6,250. Under Proposition 19, if the child does not move into the home as a primary residence within one year, the property is reassessed to $1,800,000, increasing annual property taxes to roughly $22,500. If the child does occupy the home, the reassessment is limited: the new assessed value would be approximately $1,800,000 minus $1,044,586, or roughly $755,414, resulting in a property tax of approximately $9,443 per year. Still a meaningful increase, but substantially less than full reassessment.

California Capital Gains Tax: No Preferential Rate

California is one of the most aggressive states for capital gains taxation, and this has direct implications for estate planning and inherited assets. Unlike the federal government, which taxes long-term capital gains at preferential rates of 0%, 15%, or 20% depending on income, California treats all capital gains as ordinary income. The California Franchise Tax Board (FTB) applies the state's progressive income tax rates, ranging from 1% to 13.3%, to every dollar of capital gain, regardless of how long the asset was held.

For estate planning purposes, this distinction matters in the following ways:

Inherited real estate: The step-up in basis (discussed in Part II) applies for California purposes as well as federal purposes. An heir who inherits California real estate and sells it promptly will owe little or no capital gains tax, at either the federal or state level, because the basis resets to fair market value at the date of death. The longer the heir holds the property after inheritance and allows it to appreciate further, the larger the eventual state capital gains tax will be at rates up to 13.3%.

Community property advantage: California is a community property state, which creates a particularly valuable estate planning benefit. When a married couple holds property as community property and one spouse dies, both halves of the property receive a stepped-up basis to current fair market value, not just the deceased spouse's 50% share. This "double step-up" is unique to community property states and can eliminate capital gains tax on all appreciation that occurred during the marriage, providing significant tax savings for the surviving spouse and eventual heirs.

Scenario: Sale of Inherited Investment Property: A California resident inherits a rental property appraised at $1,200,000 on the date of death. The parent had originally purchased it for $200,000. Thanks to the step-up in basis, the heir's new tax basis is $1,200,000. If the heir sells immediately for $1,200,000, the taxable gain is zero, at both the federal and state level. If the heir holds the property for five years and sells for $1,500,000, the taxable gain is $300,000. At the federal level, the long-term capital gains rate might be 20%, plus the 3.8% NIIT; a combined $71,400. California would separately tax the same $300,000 gain as ordinary income; at a 13.3% marginal rate, that would be an additional $39,900. Total combined tax: approximately $111,300 on $300,000 of post-inheritance appreciation.

Real estate withholding: When California real estate is sold, the buyer is generally required to withhold 3.33% of the gross sale price (or the amount of gain, whichever is less) and remit it to the FTB as an advance payment. This applies to estates and trusts selling California property, as well as individual sellers. The withholding is credited against the ultimate income tax liability, but fiduciaries should plan for this cash flow timing requirement during estate administration.

Inherited IRAs and Retirement Accounts: A California-Specific Concern

Inherited retirement accounts such as, traditional IRAs, 401(k)s, and similar plans present one of the most significant and frequently overlooked tax challenges for California beneficiaries. Understanding the interaction between federal retirement tax rules and California's income tax regime is critical.

Federal income tax treatment: Retirement accounts do not receive a step-up in basis at death. Every dollar withdrawn from an inherited traditional IRA or 401(k) is taxed as ordinary income at the federal level in the year of withdrawal. The SECURE Act (2019) eliminated the "stretch IRA" strategy for most non-spouse beneficiaries; the vast majority of heirs must now fully withdraw the inherited account within 10 years of the original owner's death.

California's additional layer: California taxes IRA and retirement account distributions as ordinary income at rates up to 13.3%. There is no state-level exemption or exclusion for inherited retirement distributions. This means a California beneficiary who withdraws from an inherited traditional IRA faces both the federal income tax rate on that withdrawal and a California state income tax of up to 13.3%.

Scenario: Inherited IRA: A California resident in the 35% federal bracket inherits a $500,000 traditional IRA. If they withdraw the full amount in a single tax year, the combined federal and California marginal tax on that distribution could approach or exceed 48%. By contrast, spreading withdrawals strategically over the 10-year window, coordinating with years of lower income, can significantly reduce the effective combined rate.

Roth IRA advantage: Inherited Roth IRAs are treated more favorably. Because taxes were paid by the original owner, qualified distributions from an inherited Roth IRA are generally income-tax-free at both the federal and California state level. California does not tax qualified Roth distributions. The 10-year distribution rule still applies in most cases, but the absence of income tax on distributions makes Roth accounts one of the most tax-efficient assets to pass to California heirs. This is a strong argument for Roth conversions as part of a California estate plan.

Life insurance: Life insurance death benefits are generally income-tax-free to beneficiaries under both federal and California law, making life insurance an efficient wealth-transfer vehicle in a high-income-tax state. However, if the insured owned the policy at death, the death benefit is included in the taxable estate for federal estate tax purposes.

California Income Tax on Trusts

California's Franchise Tax Board taxes trust income much as it taxes individual income, including capital gains at ordinary income rates up to 13.3%. Trusts that retain income within California are subject to these rates in addition to the compressed federal income tax brackets described in Part II. This double compression, both federal and state, makes income distribution planning especially important for California trustees.

One nuance specific to California: the FTB taxes trust income based on the residence of the fiduciary and the beneficiaries, not merely the location of trust assets. A trust with a California-resident trustee or California-resident beneficiaries may be subject to California income tax even if the trust assets are located outside the state. This can create unexpected tax exposure for trusts that were established in other states but are administered by California fiduciaries.

The Revocable Living Trust: Particularly Valuable in California

While revocable living trusts are commonly used for estate planning throughout the United States, they offer particular advantages in California due to the state's probate process. California's probate fees are set by statute and are based on a percentage of the gross value of the probate estate, not the net value. Under California Probate Code Section 10810, the combined attorney and executor fee schedule is approximately 4% on the first $100,000, 3% on the next $100,000, 2% on the next $800,000, 1% on the next $9 million, and 0.5% on the next $15 million. For a modest home worth $800,000, common throughout California, this can amount to statutory fees of approximately $19,000, regardless of whether the estate has any complexity.

A properly funded revocable living trust avoids probate entirely for assets held in the trust, eliminating statutory probate fees and the associated delays (California probate can take one to two years or longer). This makes the revocable living trust a particularly cost-effective planning tool in California, even for estates well below the federal estate tax threshold.

Summary: Key California Estate Planning Checkpoints

The following issues deserve specific attention for California residents working with their CPA and estate-planning attorney:

• No California estate or inheritance tax applies to decedents dying after January 1, 2005, but federal estate tax applies to estates over $13.99 million (2025).

• Proposition 19 has fundamentally changed inherited real estate planning. Parent-to-child transfers of property other than a primary residence will trigger full reassessment. Even primary residence transfers are only partially protected, with a current inflation-adjusted exclusion of $1,044,586.

• California taxes all capital gains as ordinary income at rates up to 13.3% with no preferential long-term rate. Post-inheritance appreciation is subject to both federal capital gains tax and California ordinary income tax.

• Community property titling can provide a double step-up in basis for married couples, eliminating capital gains tax on all appreciation that occurred during the marriage.

• Inherited traditional IRAs and 401(k)s are taxable as ordinary income at both the federal and California state level. The compressed 10-year distribution window under the SECURE Act demands careful withdrawal planning to manage bracket exposure.

• Roth IRA conversions are particularly attractive in California because distributions from inherited Roth IRAs are tax-free at both the federal and state level.

• Revocable living trusts are especially valuable in California to avoid the state's statutory probate fees and lengthy probate timelines.

• California income tax may apply to trust income based on the residence of the trustee or beneficiaries, regardless of where trust assets are located.

Important Disclosure

This article is provided for general educational purposes only and does not constitute legal, tax, or financial advice. Tax figures reflect 2025 federal law as of the publication date. Individual circumstances vary; consult one of our qualified CPAs and/or an estate-planning attorney before making any decisions. State laws, local rules, and future legislative changes may materially affect your situation.