One of the first questions asked by those who prepare to plan their estates is “How will my property be taxed at the time of my death?” Many are pleased to know that they need not worry about federal estate tax since Uncle Sam imposes this levy in the year 2022 only if the estate exceeds $12.06 million. The same, however, cannot be said of Pennsylvania inheritance tax. The Pennsylvania tax applies regardless of the size of the estate. There are, however, ways to reduce Pennsylvania’s inheritance tax. But to do so, you must understand some of the ground rules.
The Pennsylvania inheritance tax is technically a tax on the beneficiary’s right to receive your property. The amount of tax a beneficiary pays depends on the value of the property they receive and their relationship to you. Traditionally, the Pennsylvania inheritance tax had two tax rates. A rate of six percent applied to assets that passed to so-called lineal descendants, such as children, grandchildren and stepchildren. A rate of 15% applied to so-called collateral beneficiaries. This included brothers, sisters, nieces and nephews and all others. Transfers to charities were exempt from tax as were assets owned by spouses with rights of survivorship. These two rates were the law until 1995 when a third rate was introduced. That third rate is a zero percent rate that applies to assets that are left to a spouse. This spousal exemption is discussed in another article.
However, former Governor Ridge signed a tax act on May 24, 2000, that cut these rates. Under the 2000 tax changes, the six percent rate was reduced to 4.5% effective for those who die after June 30, 2000. As such, if you leave your children $100,000, the tax bite will now be $4,500. That’s $1,500 less than it would have been under the old law. In addition to children, this new 4.5% rate also applies to assets that are left to grandchildren, stepchildren, and parents.
The 2000 tax act also introduced a new rate for transfers to siblings. Siblings are defined to include those who have at least one parent in common with the decedent, whether by blood or adoption. Assets that pass to siblings are now be taxed at 12%. Once again this applies to decedents dying after June 30, 2000. Unfortunately, the 15% rate stays in place for things you leave to nieces and nephews, same-sex partners (but not a same-sex spouse) and unrelated beneficiaries.
The another change under the 2000 tax act has to do with an “exemption” from tax that applies to assets that pass from a child to a parent. Upon the death of a child age 21 or younger, there is no longer any tax on assets that pass to that child’s parent or stepparent. Technically, they are subject to tax, but the rate is 0%. Finally, under another change effective for deaths after 2019, the same can be said for assets that pass to a child or stepchild under the age of 21. Now, too, those are taxed at 0%.2
For many, these tax rates sound steep. Fortunately, however, the tax is not imposed on the gross value of your estate. First, when your executor or administrator prepares the tax return, they will get to deduct debts that you owed, funeral expenses and any other estate settlement costs. A $3,500 family exemption may also be available as an additional deduction. Secondly, certain property is exempt from the tax altogether. The most important exemption is for property that is owned jointly by a husband and wife. Therefore, if you and your spouse own all of your property jointly, upon death of the first spouse there will be no Pennsylvania inheritance tax. As a technical matter, property owned individually by one spouse is subject to tax even though it passes to the surviving spouse under the terms of a Will. However, since the current tax rate on property passing to a spouse is zero percent, it doesn’t create any tax.
Life insurance proceeds are also exempt from Pennsylvania inheritance tax. So, too, are the benefits from many retirement plans, but you have to weave through technical rules to make sure it’s exempt. Unfortunately, it’s safe to say that the Department of Revenue says that an IRA is subject to inheritance tax if the decedent was over age 59½ at the time of death. Two other exemptions were recently created by Act 85 of 2012. These exemptions are effective for estates of those who died after June 30, 2012. For those estates, many farms will now be exempt from inheritance tax if they pass to so-called lineal descendants or siblings. Finally, Act 52 of 2013 added an exemption for the transfer of a “qualified family-owned business” for those dying after June 30, 2013. In general terms, to meet this exemption, the business must have fewer than 50 employees and a net book value of less than $5 million and it must pass to a spouse, lineal descendants (children, grandchildren, etc.), siblings, the lineal descendants of siblings, ancestors (parents, grandparents) and siblings of ancestors.
While these exemptions are nice, certain other property is subject to tax even though you may not have owned property at the time of your death. For instance, if you gave your entire estate to a child, but failed to survive that gift for a period of one year, that gift would be subject to a 4.5% inheritance tax to the extent it exceeded $3,000. Also, suppose you give your house to your son but reserve the right to live there for the rest of your life. Because you reserved this right, the entire value of the house would be taxed upon your death.
As you can see, many factors will influence the amount of inheritance tax your estate will have to pay. These include the type of property you own, the manner in which you own your property and the relationship of your intended beneficiaries. As is the case with any other tax matter, proper planning can save taxes and ensure that you pass along all that you’re worth.