Why liquidity matters for estate taxes

Estate taxes, probate costs, and final expenses can create immediate cash needs for an estate. When assets are mostly illiquid—real estate, privately held business interests, collectibles—heirs may be forced to sell parts of the estate quickly, often at a discount, to raise cash. That can be emotionally and financially damaging.

In my practice as a CPA and CFP®, I’ve seen estates where a family home or a business had to be sold under duress to satisfy tax bills. Proper liquidity design reduces that risk and preserves the owner’s intent. This article outlines practical strategies, trade-offs, and implementation steps you can use or discuss with your advisors.

Key sources and laws to check

  • IRS estate tax guidance and Form 706 instructions are the primary federal references for estate tax calculations and filing deadlines (see IRS Estate Tax pages).
  • State-level estate or inheritance taxes differ by state and can impose separate liquidity needs—check your state tax agency.

Always confirm the current federal exemption and rates on the IRS website before planning, since exclusion amounts are indexed and subject to legislative change (IRS: Estate Tax).

Practical steps to design liquidity

Below are the most commonly used approaches, their advantages, limitations, and implementation tips.

1) Maintain a targeted liquid allocation

  • Strategy: Hold a planned percentage of the estate in highly liquid assets (cash, high-quality bonds, money market funds, publicly traded ETFs).
  • Why it helps: These assets can be accessed quickly to pay estate taxes, executor fees, and immediate family needs.
  • Rule of thumb: There’s no one-size-fits-all percentage. Start by estimating likely tax and settlement costs, then add a buffer (e.g., 10–20% of that estimate). The exact amount depends on asset mix, credit availability, and family tolerance for risk.
  • Implementation tip: Rebalance periodically to ensure liquidity targets remain as asset values change.

2) Use life insurance to create dedicated liquidity

  • Strategy: Own a life insurance policy in an appropriate ownership structure so proceeds are available to pay estate taxes.
  • Typical structures: Irrevocable life insurance trusts (ILITs) are commonly used to keep proceeds out of the insured’s taxable estate while providing liquidity to heirs.
  • Pros: Death benefit is generally fast, predictable, and tax-free to beneficiaries; avoids forced sales.
  • Cons: Requires premium funding and proper legal setup. If owned by the decedent at death, proceeds may be includible in the estate, undermining the goal.
  • Implementation tip: Work with an estate attorney to fund an ILIT correctly and observe the three-year lookback rule for transfers if applicable.

3) Use credit facilities strategically (estate or bridge loans)

  • Strategy: Establish a committed line of credit or lender relationship that an executor or trustee can draw against to pay taxes promptly.
  • When it works: For estates with valuable collateral (real estate, marketable securities), lenders may provide short-term loans at reasonable terms.
  • Pros: Preserves long-term assets and avoids distress sales; flexible timing to sell illiquid assets.
  • Cons: Loan fees, interest, and underwriting delays; not all estates qualify.
  • Implementation tip: Discuss with lenders during the owner’s lifetime to document collateral and approval conditions — it’s easier to obtain credit when relationships are set up in advance.

4) Convert a portion of illiquid assets to liquid vehicles ahead of time

  • Strategy: Systematically sell a portion of illiquid holdings or diversify into marketable securities, ETFs, or investment-grade bonds during life.
  • Pros: Reduces future liquidity pressure and may capture favorable market conditions.
  • Cons: Tax consequences (capital gains) and potential lost growth if the asset performs well.
  • Implementation tip: Use phased liquidation or 1031 strategies for real estate where appropriate (work with a tax advisor). See our guide on using 1031 exchanges for personal real estate strategies for specifics.

5) Use trusts and payout structures to manage liquidity for beneficiaries

  • Strategy: Design trusts that provide regular distributions or hold specific liquid assets within the trust to cover tax liabilities and beneficiary income needs.
  • Examples: A trust can hold securities that produce dividends or scheduled distributions (annuities or laddered bond portfolios) to match expected cash needs.
  • Pros: Encourages orderly administration and can provide creditor protection.
  • Cons: Trust drafting must balance beneficiary access, tax efficiency, and estate inclusion rules.

6) Gift and transfer strategies to lower the taxable estate

  • Strategy: Use lifetime gifting (annual exclusion gifts, lifetime exemption gifting, or charitable transfers) to reduce estate size and thus future liquidity needs for estate taxes.
  • Pros: Lowers eventual tax exposure; gifts can be structured to leave heirs with funds before death.
  • Cons: Gift taxes, step-up basis issues, and potential loss of asset control.
  • Implementation tip: Coordinate gifting with liquidity needs—small lifetime gifts can give heirs ready cash for future tax bills without shrinking your immediate liquidity.

Estimating the estate’s liquidity gap

A practical planning exercise:

  1. Inventory assets and estimate fair market values and how much is liquid versus illiquid.
  2. Estimate potential estate tax liability (use current IRS rules or work with a tax advisor). Don’t forget state estate or inheritance taxes where applicable.
  3. Add settlement costs—probate fees, executor fees, unpaid debts, and final medical or funeral bills.
  4. Subtract existing liquid assets and designated insurance proceeds.
  5. The shortfall is your liquidity gap; design strategies above to close that gap or provide temporary financing.

If you prefer a template, I provide clients a simple worksheet that compares estimated taxes and costs to existing liquid holdings and insurance; a planner or attorney can help you refine assumptions.

Real-world trade-offs and examples

  • Life insurance vs. market liquidity: A $1M policy can provide immediate certainty but costs premiums during life. In contrast, holding $1M in cash reduces growth potential but requires no ongoing premiums.
  • Borrowing to pay taxes: A well-structured bridge loan can protect a family-run business from a fire sale, but interest costs and covenants can reduce flexibility.

Example (anonymized): A family with $8M of real estate and $1M in cash faced a potential federal/state tax and settlement bill of $1.2M. Rather than sell property at a depressed seasonal market, we set up a short-term lender line secured by the portfolio and purchased a targeted life insurance policy for liquidity. The lender provided time to market properties, while insurance covered part of the tax, preserving the family’s core assets.

Coordination with other planning areas

  • Business owners: Your business valuation and buy-sell agreements must consider liquidity. See our Estate Planning Checklist for Business Owners for additional steps.
  • Real estate investors: Consider 1031 exchanges and title structures; refer to our guidance on using 1031 exchanges in personal real estate strategies.
  • Retirement couples and phased transfers: Couples should model spousal portability and phased wealth transfers; see our article on estate liquidity planning for retirement couples.

Common mistakes to avoid

  • Assuming estate taxes won’t apply: Many owners overestimate the protection of exemptions without considering state taxes or future law changes.
  • Waiting until death to create liquidity: Markets may be unfavorable, and executors lack time.
  • Incorrect insurance ownership: If life insurance is owned by the insured and included in the estate, the policy can increase estate tax exposure unless held in an ILIT.

Checklist to get started (practical next steps)

  • Run an up-to-date net-worth and asset-liquidity inventory.
  • Get a current estate tax projection from a CPA or estate attorney (include state exposure).
  • Evaluate whether existing life insurance is properly owned and sufficient for projected needs.
  • Consider lender relationships and whether a pre-approved line of credit is feasible.
  • Update wills, trusts, and beneficiary designations to reflect liquidity objectives.
  • Review plans annually or after significant life events.

Professional disclaimer

This article is educational and does not replace personalized tax, legal, or financial advice. Estate and tax laws change; consult a qualified estate attorney, CPA, or CFP® before implementing strategies. For federal guidance, see the IRS estate tax pages and Form 706 instructions.

If you’d like, I can provide a sample liquidity worksheet and a short list of questions to bring to your estate planning meeting with advisors.