This is an update to the 2018 post on wrote on the Pennsylvania inheritance tax. However, before I discuss ways to minimize the PA inheritance tax, it is important to understand that the tax rate is affected by who receives money upon your death.
As a refresher, Pennsylvania has an inheritance tax on most assets that are transferred at the time of your death if they are going to anyone besides a spouse or a charity. There is also no inheritance tax if a child under age 21 dies and leaves their estate to their parent or step-parent.
Pennsylvania Inheritance Tax on Assets Passing to your Children, Grandchildren, Parents and Grandparents
- There is a flat 4.5% inheritance tax on most assets that pass down to your children, grandchildren, great-grand children or your other descendants.
- There is a flat 4.5% inheritance tax on most assets that pass up to your parents, grandparents or your other lineal ascendants. (Exception if the decedent is under age 21.)
- Pennsylvania treats a son-in-law or daughter-in-law as if they are a child for purposes of the inheritance tax. As a result, there is a flat 4.5% PA inheritance tax on assets that pass to the wife or widow and husband or widower of the decedent’s child.
Pennsylvania Inheritance Tax on Assets Passing to your Brothers, Sisters, Nieces, Nephews, Friends and Others
- There is a flat 12% inheritance tax on most assets that pass to a sibling (brother or sister).
- There is a flat 15% inheritance tax on most assets that pass up to nieces, nephews, friends and other beneficiaries. (This means there will be 15% tax on money you leave to your dog, cat or horse.)
7 Simple Ways to Minimize the Pennsylvania Inheritance Tax
1. Set up joint accounts with the people you wish to benefit.
Pennsylvania will only tax the percentage of assets owned by the decedent, not the full amount.
- This is a particularly useful strategy if you have one child that you trust completely as only one-half of the jointly owned assets will be taxed. However, if you have more than one child, it is possible that you and all the children are joint owners of the account, so if you have three children, only 1/4 of the account will be subject to the PA inheritance tax.
- If you have more than one child, be careful of setting up a joint account with just one person (because you may accidentally cut your other children out)
- Be sure that you don’t have any concerns that your child will take your money and it won’t be available for you to use.
- Transfers must occur more than one year before death to achieve the maximum tax benefit.
2. Gift your assets to your children.
This can be a very dangerous strategy, so I strongly recommend consulting with a tax attorney or accountant before making the gift.
- Dangers include giving away an asset that has a low basis resulting in a capital gains tax which could be far more expensive than simply paying the PA inheritance tax.
- If you give away too much, you could be subject to federal gift taxes or generation skipping transfer taxes.
- This could potentially cause problems if you wish to qualify for Medicaid.
3. Buy extra life insurance.
The death benefit paid out on a life insurance insurance policy is not subject to the Pennsylvania inheritance tax. So converting non-life insurance assets to life insurance will reduce the tax. Another interesting planning opportunity is to buy a long term care insurance policy that has a life insurance rider. This way if you don’t use up the LTC policy, it can pass tax free to your heirs.
4. Utilize life insurance to give money to beneficiaries who are taxed at the highest tax rates.
Let’s assume the following fact pattern. You have total assets of $1.1 million dollars including a life insurance policy worth $100,000. Your goal is to leave $100,000 to your nieces and nephews and you want to leave the rest of your estate to your children.
- If you have name your nieces and nephews the beneficiary of the life insurance and give the rest of your assets to your children, there will be a total PA inheritance tax of $45,000 (4.5% x $1M).
- If you give the children the life insurance money, and have a will leaving your nieces and nephews $100,000 from your Will with the rest to the children, the total PA inheritance tax will be $55,500 (15% x $100,000 + 4.5% x $900,000).
Accordingly, the overall strategy is to give assets that do not cause an inheritance tax to the beneficiaries with the highest marginal tax rate.
5. Buy real estate outside of Pennsylvania.
OK, maybe this isn’t very simple. However, Pennsylvania only taxes assets located in Pennsylvania. Accordingly, a shore property in New Jersey will pass free of the PA inheritance tax.
- Beware of taxes in other states
- Don’t put the real estate in an entity such as an LLC – Pennsylvania reserves the right to tax an interest in business. (The legal theory is that you no longer own real estate, but the LLC, which is subject to a PA inheritance tax.)
6. Pay the PA inheritance tax early.
If you pay the Pennsylvania inheritance tax within 3 months from date of death, you are entitled to a 5% discount.
7. Convert your IRA to a Roth IRA.
The conversion will come at a cost, since you will need to pay an income tax on the conversion. The benefit of paying the income tax before you die though is that it reduces your PA taxable estate for inheritance tax purposes.
- This strategy works best when you have enough funds outside your retirement account to pay for the income taxes on the conversion.
- This strategy is especially valuable if your children are high income earners, this way they can receive distributions from the ROTH, after your death, free of income tax.
- I strongly recommend consulting with a tax attorney or accountant though before doing the conversion.
- This strategy is often best to do over multiple years (converting a little bit each year).
Other Not-So-Simple Ways to Minimize the PA Inheritance Tax
- Move to another state. Again, this may not be simple for many people, but if you already have a property in another jurisdiction, consider whether you should change your domicile for tax purposes. (Obviously you must actually meet the requirements of changing your domicile.)
- Invest in farmland or a family business. Pennsylvania exempts certain farmland and small businesses from the inheritance tax. The problem with this may be getting your money back out of the business.
- Setting up a GRAT or GRUT (setting up a special type of trust that creates an annuity back to you and gives excess investments to your heirs).
- Setting up a CLAT or CLUT (setting up a special type of trust that creates an annuity to charity and leaves the rest to your heirs).
- Leave IRA money to a CRAT or CRUT (setting up a special type of trust that creates an annuity to your heirs and leaves the rest to charity).
- Setting up a spousal access trust. These are typically over-funded life insurance trusts. Money can be used for your spouse and children while you are alive and then it goes completely tax free to your children. This is a fantastic way to minimize the federal estate tax as well as minimizing the PA inheritance tax.
Simple is Never Simple
As always, be very careful that any changes you make to beneficiary designations or joint ownership of accounts could dramatically alter your overall plan. It never hurts to run what might seem like a simple change by an estate planning attorney.