Rolek Retirement Planning

How to Avoid Pennsylvania Inheritance Tax | Pennsylvania Retirement Planning

- By Kyle Rolek, Fiduciary Financial Advisor and Certified Financial Planner

How do I avoid inheritance tax in PA? There are practical ways to reduce the impact of Pennsylvania inheritance tax while maintaining PA residency. You don’t necessarily need to move to a state without an estate tax or inheritance tax. Less drastic steps can also be effective. 

Who pays the inheritance tax in PA?  

PA inheritance tax is due when a PA resident who owns property dies, or when an out-of-state resident dies that had property located in PA. An inheritance tax return must be filed within 9 months of the date of death. The person named as personal representative in the will or as the administrator of the estate is required to file the inheritance tax return. The inheritance tax return is generally filed with the Register of Wills in the county where the PA resident died or owned property. Either the recipients of the property or the estate pay the PA inheritance taxes depending on how instructions were written into the will.

How much is inheritance tax in PA?

  • The PA inheritance tax rate is 0% for property passed to a surviving spouse or a child under age 21
  • The PA inheritance tax rate is 4.5% for property passed to direct descendants and lineal heirs
  • The PA inheritance tax rate is 12% for property passed to siblings
  • The PA inheritance tax rate is 15% for property passed to other heirs (excluding charities and organizations that are exempt from PA inheritance tax)

Pennsylvania inheritance tax example:

  • John and Jane are married.
  • John dies first. All property can pass to Jane without any PA inheritance tax.
  • Once Jane dies, property will be passed to their kids, grandkids, Jane’s sister, and a friend.
  • For property received by their kids when Jane dies, the PA inheritance tax rate is 4.5%. For every $100,000 in property received by the kids, the PA inheritance tax bill will be $4,500.
  • For property received by the grandkids when Jane dies, the PA inheritance tax rate is 4.5%. For every $100,000 in property received by the grandkids, the PA inheritance tax bill will be $4,500.
  • For property received by Jane’s sister, the PA inheritance tax rate is 12%. For every $100,000 in property received by Jane’s sister, the PA inheritance tax bill will be $12,000.
  • For property received by the friend when Jane dies, the PA inheritance tax rate is 15%. For every $100,000 in property received by the friend, the PA inheritance tax bill will be $15,000.
  • If the Pennsylvania inheritance tax payment is made within 3 months of the date of death, a 5% discount is applied. 

Method #1 to Avoid Pennsylvania Inheritance Tax: Gifting

Assets gifted more than 12 months prior to death are excluded from PA inheritance tax.

There is no limit to the amount that can be gifted each year. Gifts can be taxable, but very few people ever have to pay a gift tax. There is a $15k “annual gift tax exclusion”, which means that $15k or less can be gifted from one person to another during a year without the gift reducing your “lifetime gift tax exemption”, which is about $11.5m for 2020.

For example, if you gift $25k in 2020 to one person, which is $10k above the “annual gift tax exclusion” limit, your lifetime gift tax exemption is reduced by $10k from $11.5m to $11.49m. Other than slightly reducing the lifetime gift tax exemption of the donor, there is no actual tax implication to either the donor or the recipient (the donor does have to file a gift tax return). Again, most people will never have to pay any gift tax.

Based on estate law as of 2020, the lifetime gift exclusion also serves as the federal estate tax exemption amount. As a result, reducing your lifetime gift exclusion by gifting over $15,000 per recipient in a year will also reduce your federal estate tax exemption. With the large amount of the current exemption, this doesn’t matter in most cases. However, it’s possible that the lifetime gift tax exclusion and federal estate tax exemption will be reduced in the future. For example, the estate tax exemption was $675,000 as recently as 2001 and has increased very significantly into the tens of millions for married couples only recently. It’s generally good planning to keep gifts below $15,000 per recipient per year, which doesn't reduce your lifetime gift or estate tax exemptions at all, in case the lifetime gift and estate tax exemptions get reduced significantly by law change in the future. However, there are also situations when gifting above this $15,000 threshold per recipient per year can make good financial sense too. 

When the majority of liquid assets are held within a Traditional IRA or other pre-tax retirement account, this can present some tax challenges for gifting. You'd have to take a taxable distribution from your IRA account to gift the money. Clearly, paying income taxes on money you don’t really need isn’t desirable. As a result, those who have a well-built retirement plan with a strong foundation and are financially secure will consider gifting their Required Minimum Distributions, which is money they needed to take out of their IRA accounts anyway. When this money is gifted, they aren’t incurring any unnecessary income taxes, and they are avoiding PA inheritance tax for the dollars gifted during their life (assuming they live for at least 12 months after the gift is provided).

Gifting is especially beneficial when the beneficiaries of property will be siblings (subject to a 12% PA inheritance tax rate) or those who fall in the “other” category (subject to a 15% PA inheritance tax rate). In the example above, from a tax planning perspective it would probably make sense for Jane to gift to her friend first, siblings second, and lineal heirs last. For example, if she gifts property to her friend during her life at least 12 months prior to her death, 15% of the property will be saved from PA inheritance taxes. Any property gifted to lineal heirs saves only 4.5% in PA inheritance tax. As Jane gifts, she can adjust her will to make sure each party ends up receiving the intended amount with both gifts during life and property received at death considered. There will of course be other personal considerations that factor into this as well. We are solely focused on potential PA inheritance tax savings strategies here.

Another category related to gifting is trust planning. When assets are contributed to certain types of trusts, including irrevocable trusts, PA inheritance tax can potentially be avoided. However, this isn’t true in all cases. It’s important to work with an experienced Pennsylvania estate planning attorney to make sure trust planning is handled correctly and trust language is drafted appropriately. As a fiduciary financial advisor, we’ll get an experienced Pennsylvania estate planning attorney involved in our retirement planning process to design the estate plan, including trusts when appropriate, to coordinate well with the overall financial plan.

Method #2 to Avoid Pennsylvania Inheritance Tax: Buy Farmland and Agricultural Property

This is out of the box and obviously not appropriate in all cases. However, effective for those who die after June 30, 2012, agricultural property and farmland is excluded from PA inheritance tax in certain cases.

The qualifying property must be transferred to members of the same family, it must have operated in the agriculture business at the time of the owner’s death, it must remain in the agriculture business for at least 7 years following the owner’s death, and it must produce at least $2,000 of annual revenue from the business of agriculture. While this technique won’t be relevant in the majority situations, under conditions where a family was already involved in or intended to get involved in the agriculture business anyway, proper planning can be very beneficial towards avoiding PA inheritance taxes.

Method #3 to Avoid Pennsylvania Inheritance Tax: Buy Real Property in a State Without Estate or Inheritance Tax

Real property and tangible personal property located in Pennsylvania at the time of a PA resident’s death is subject to PA inheritance tax. Real property and tangible personal property located outside of Pennsylvania is not subject to PA inheritance tax.

Safety Tip Regarding Life Insurance

Is life insurance taxable in PA? No. Life insurance is excluded from PA inheritance tax. As a result, you may get advice to buy a life insurance policy to pass assets to beneficiaries without beneficiaries or your estate needing to pay PA inheritance tax. However, buying life insurance for the sole purpose of avoiding PA inheritance tax is bad advice. The advice is probably being provided by a salesperson more intent on chasing commissions for themselves rather than providing sound financial advice to you. If you are purchasing life insurance to save money on PA inheritance taxes, you are essentially purchasing life insurance as an investment. Taxes, costs, rate of return, liquidity, and other factors need to be carefully considered and compared with all other alternatives, including "normal" investments that aren't insurance products, before proceeding.

It’s likely that after careful analysis, you’ll find that purchasing life insurance as an investment does not compare favorably versus other alternatives. If the true goal is to minimize PA inheritance tax, then a life insurance policy can work fine. But so can spending all of your money so there’s nothing left to be taxed. Keep in mind that the real goal is probably something closer to protecting your own financial security and passing assets efficiently to heirs, not necessarily to minimize PA inheritance tax at all costs. A fiduciary financial advisor, one who does not get paid hidden commissions to sell products or policies, can help you objectively assess the best course of action your unique situation. 

In summary, there are practical ways to reduce the impact of PA inheritance tax without necessarily needing to move to a state without estate tax or inheritance tax.

As a Pennsylvania fiduciary financial advisor who specializes in retirement planning, estate planning, including PA inheritance tax planning, fits well within our scope of work. We’ll get an experienced Pennsylvania estate planning attorney involved and work together to design an estate plan that coordinates well with your overall retirement planning.

Think you should hire a Fiduciary Financial Advisor with retirement planning expertise? Fill out the “Request Consultation” form, call us at 267-427-5667, or email kyle.rolek@rolekretirement.com