How to Avoid and Minimize Pennsylvania Inheritance Tax
Pennsylvania is one of six states that impose inheritance taxes. The law requires certain heirs of estates to pay taxes on the inheritance they receive, depending on their relationship to the decedent. Inheritance tax is different from estate taxes, which are based on the size of the estate.
Instead of being imposed on the estate, inheritance taxes are levied on the specific inheritances of each listed beneficiary. The rates range from 4.5% to 15%, but there are exemptions, too. Properly planning your estate can help you reduce your inheritance tax liability. This guide covers the strategies to best manage your inheritance tax liability.
The Basics of Inheritance Tax in Pennsylvania
Inheritance tax is a percentage charge on the decedent’s estate transferred to their beneficiaries. There is no bottom threshold, meaning beneficiaries may be required to pay inheritance tax regardless of the size of the estate.
The Pennsylvania inheritance tax rates vary depending on the beneficiary’s relationship with the decedent. They are as follows:
- Transfer of assets to a surviving spouse or parent from a child age 21 or younger is 0%.
- Transfer of assets from a parent to or for the use of a child age 21 or younger is 0%.
- Transfer of assets to lineal heirs and direct descendants is 4.5%.
- Transfer of assets to siblings is 12%.
- Transfer of assets to non-exempt beneficiaries is 15%.
Direct descendants are the decedent’s children and all descendants of the decedent’s children thereafter. Lineal heirs include grandparents, parents and their children. Children in this case are defined as biological, adopted and stepchildren.
Typically, the taxes are levied after certain expenses are deducted from the estate, including:
- Legal fees
- Funeral costs
- Medical expenses
- Fees paid to the Register of Wills
- Debts such as mortgage loans, credit cards and home equity loans
- Other miscellaneous expenses
Inheritance tax is due nine months after the decedent’s death, but there is a 5% discount if beneficiaries pay within three months. Tax not paid by nine months begins to accrue interest.
What Assets Are Subject to Pennsylvania Inheritance Tax?
Here are examples of assets that may be subject to inheritance tax in Pennsylvania:
- Real estate: Real estate includes land and any permanent structures attached to it. The property could be residential or commercial, like single-family homes, condominiums, townhouses, stores, restaurants and office buildings. While real estate is generally taxable, the relationship between the decedent and beneficiaries may determine otherwise.
- Tangible personal property: These assets can be touched and physically relocated, like vehicles, furniture, household appliances and business equipment. Generally, tangible assets with value will incur inheritance tax, so it’s best to have them appraised. Even when the appraiser determines the assets have no monetary value and are non-taxable, it’s still necessary to report this on Schedule E of the Pennsylvania inheritance tax return.
- Intangible personal property: Unlike tangible assets, intangible personal property is non-physical and includes patents, trademarks, copyrights, licenses and royalties. These assets have monetary value and are generally taxable.
What Assets Are Not Subject to Pennsylvania Inheritance Tax?
Some assets may be excluded from inheritance tax in Pennsylvania. Here are some examples:
1. Life Insurance
Proceeds from life insurance, whether paid to the decedent’s estate or directly to a named beneficiary, are usually exempt from estate taxes. Designating beneficiaries to your life insurance coverage is vital to protect the proceeds from creditor claims. Refunds from unearned life insurance premiums for the current policy period and post-death dividends are exempt from inheritance tax.
2. Properties Jointly Owned by Spouses
Assets jointly owned by spouses with a right of survivorship, including real estate and bank accounts, are generally exempt from inheritance taxes in Pennsylvania. Right of survivorship is a type of joint property ownership where the property transfers automatically to the surviving co-owners when one owner dies.
Married couples in Pennsylvania may own real estate as “tenants by the entireties.” In this arrangement, the couples have an equal ownership share in the property. Each person is deemed to own 100% of the real estate.
You may report jointly owned assets on the tax return Schedule F. However, for married couples, reporting is unnecessary. Similarly, if all the assets are jointly owned spousal property, there is no need to file an inheritance tax return.
3. Inheritance Between Spouses
When a spouse passes away, their individually owned assets may transfer to the surviving spouse, either in accordance with the decedent’s will or operation of law. Unlike jointly owned property, these assets must be reported in the inheritance tax return. The reason is that they are technically taxable, but the rate is zero. In other words, the surviving spouse must file an inheritance tax return to report the asset transferred to them, taxed at 0%.
4. Inheritance From Minor Child to Parent or Parent to Minor Child
When children aged 21 years or younger pass away before their parents, assets that transfer from that child to the surviving parent are free from inheritance tax. Similarly, if a parent passes and transfers assets to children aged 21 or younger, those assets are also free from inheritance tax. Like inheritance between spouses, these assets are technically taxable but at 0%. These exemptions apply to assets transferring to or from natural parents, stepparents or adoptive parents.
5. Inheritance From Certain Members of the Military
When a service member of the military passes due to illness or injury suffered on active duty, personal property transferred from their estate is exempt from inheritance tax.
6. Farmlands and Agricultural Property
The Pennsylvania inheritance tax legislation has carved out exemptions for certain farmlands and agricultural properties. If a family member inherits farmland and continues to use it for agricultural purposes for seven years, that property may be exempt from inheritance tax.
This exemption has special rules. It’s best to consult an experienced attorney or review the Pennsylvania Department of Revenue Inheritance Tax Information Notice 2021-01 for more information.
7. Family-Owned Businesses
Small family-owned businesses with assets valued under $5 million and fewer than 50 employees are exempt from inheritance tax. The caveat is that the company must exist for at least five years, be inherited by family members and stay in operation for another seven years. Certifications must be done for each of these seven years and are due on February 15 of each year. The business’s sole purpose cannot be managing investments or income-producing assets of the entity. Where the business transfers to a trust, the sole beneficiaries must be members of that same family. The exemption must be reported on the inheritance tax return.
8. Assets Passing to the Government
In some limited instances, assets may transfer to the government by operation of law. One example is when a decedent dies intestate, or without a will, without beneficiaries to inherit the property. In that case, the estate assets may be distributable to the Commonwealth of Pennsylvania as a “statutory heir” without any inheritance tax. Also, gifts made to the United States government, the Commonwealth of Pennsylvania and political subdivisions are exempt from inheritance tax.
9. Charitable Gifts
Gifts made to charitable organizations are generally exempt from inheritance taxes. For the exemption to apply, you must gift the property through a will, trust or beneficiary designation. If the executor, administrator or beneficiary donates to charity in memory of the decedent, that transfer may incur inheritance tax.
10. Property Situated in Another State
Only six states in the U.S. have inheritance taxes, with Pennsylvania being one of them. So, if you want to bypass inheritance tax, you can acquire assets outside the state. Tangible personal assets and unsold real estate outside Pennsylvania titled in the decedent’s name may be exempt from inheritance tax. However, if there was an agreement to sell real estate before death, the proceeds received after death may be subject to inheritance tax.
11. Advancements
If a person passes away intestate but gives property to an heir during their lifetime, that property may be treated against the heir’s share of the estate. That arrangement is called an advancement.
For advancement to be successful, the decedent must put the arrangement into writing, and the heir must also acknowledge it expressly. Unless the advancement occurred within a year of death, it may be exempt from inheritance tax. It’s best to consult an attorney when making this arrangement to ensure it’s documented properly and not misclassified as a gift.
12. Property Subject to a Family Exemption
The Pennsylvania inheritance tax family exemption is reserved for members of the same household. The beneficiary must also have resided with the decedent at the time of death. There is a specific order for claiming the exemptions, which is as follows:
- Surviving spouse
- Child
- Parent
A family exemption cannot be claimed against non-probate or joint property. Beneficiaries can take the exemption as a deduction on Schedule H of the Pennsylvania Inheritance Tax Return Form Rev 4500. The family exemption is limited to $3,500.
13. Retirement Accounts and Social Security
Pennsylvania State Employees’ Retirement System payments are generally exempt from inheritance tax. Individual retirement accounts (IRAs) and 401(k)s belonging to persons who died before turning 59 ½ are also exempt. However, if the account holder died before attaining age 59 ½ but had a disability, the IRA or 401(k) may be subject to inheritance tax.
A Roth IRA may incur inheritance tax regardless of the account holder’s age at the time of death or disability status. Also, if a 401(k) owner died before attaining the age of 59 ½ but had a legal right to terminate the plan during their lifetime, the account may incur inheritance tax regardless of disability status or age.
When a lump sum death benefit from the Social Security Administration is paid directly to a family member or decedent’s estate, that amount is usually exempt from inheritance tax in Pennsylvania.
Strategies to Minimize or Avoid Inheritance Tax in Pennsylvania
1. Lifetime Gifts
When a property owner gifts an asset more than 12 months before death, that asset may be excluded from Pennsylvania inheritance tax. The gifts may be to family members or charity.
For 2023, an annual federal gift tax exclusion of $17,000 applies to each donee. So if, for example, you give each of your children $17,000, there will be an annual exclusion on each gift. However, if you gift one donee beyond the limit, the excess generally incurs gift taxes.
The gift exclusion amount is subject to change, so you must pay close attention or consult a professional for regular updates.
2. Marital Deductions
As earlier indicated, property jointly owned by spouses is generally exempt from inheritance taxes, and inheritance from a spouse incurs a 0% tax rate. Property arrangements between spouses, like marital trusts, are also exempt from inheritance taxes.
For example, a person may create a trust, leaving properties for their spouse for their lifetime and direct that they transfer to their children when the receiving spouse dies. There will be no taxes when the spouse creating the trust dies. Instead, the trust will be taxed as part of the receiving spouse’s estate. The law also allows spouses to elect to pay taxes when the first spouse dies or defer until the second spouse dies.
3. Charitable Donations
Assets bequeathed to charitable organizations are typically exempt from inheritance taxes. One effective way to bequeath assets to charity is by creating a charitable remainder trust (CRT), an arrangement that distributes assets to designated beneficiaries over a stated duration. Once the period expires, the remaining assets are donated to a charity of choice.
Another option is a charitable lead trust (CLT), where financial support is made to one or more charities for a specified period. After that, the remainder is distributed to the family or other beneficiaries.
4. Irrevocable Life Insurance Trusts (ILITs)
The arrangement allows you to create a trust that holds one or more life insurance policies for designated beneficiaries. In other words, the trust holds one or more life insurance policies on the settlor’s life for other people.
The settlor may transfer cash to the trust to purchase life insurance policies or transfer an existing policy to the trust. However, if the settlor transfers a policy to the trust, there could be tax liabilities if they die within a specified period.
5. Generation-Skipping Trusts
Generation-skipping trusts (GSTs) are irrevocable trusts created for future generations. Instead of passing the property to your children, your grandchildren may be the ultimate beneficiaries. The caveat is that the beneficiary should be at least 37 ½ years younger than the grantor. GSTs allow you to compound growth, preserve wealth within the family and avoid double inheritance taxation. The arrangement also gives you control over asset distribution.
However, very large estates — over $11.4 million for an individual or $22.8 million for a married couple — still have to pay estate taxes and a 40% generation-skipping transfer tax on all money over the exempted amount.
Benefits of Professional Help With Minimizing Pennsylvania Inheritance Taxes
Here are five reasons why you need a professional to help minimize inheritance taxes in Pennsylvania:
- Avoid costly mistakes: Inheritance taxation is technical and requires insight. Professionals can provide you with accurate information to protect your assets.
- Leverage tax minimization strategies: Professionals like attorneys and financial advisors have the knowledge and experience to provide practical solutions to your needs.
- Address complex estate issues: Some individuals and families in Pennsylvania have complex estates that require special care to plan. You can leverage professional guidance to maneuver these challenges.
- Ensure proper documentation: Proper estate planning largely relies on appropriate documentation since errors can nullify your arrangements or incur unnecessary costs. Tax and estate professionals can help you ensure all paperwork is done correctly.
- Ensure peace of mind: Partnering with attorneys takes the load off your shoulders, allowing you to focus on other essential things.
Contact MPL Law for Professional Estate Planning
MPL Law Firm helps individuals and families in Pennsylvania to find strategies to reduce inheritance tax burdens for their beneficiaries. We have years of experience providing tailored solutions. If you need help planning your estate or want to learn more about how we can help you, contact us today!