Ask the Adviser: What can I do to offset PA inheritance tax for my heirs?

Q: I’m a PA resident working on my estate plan. What can I do to offset PA inher­i­tance tax for my heirs?

In many ways, Pennsyl­vania offers an ideal tax environment for retirees, with low sales tax and no pension tax. Yet there’s no avoiding PA inher­i­tance tax. If you’re a PA resident with assets to pass on, those assets will be subject to inher­i­tance tax when you pass away. This affects every resident with assets, not just those with large assets.

Thank­fully, there are some things you can do now to help your heirs with the bill. Here, we’ll look at a variety of strategies—some simple, others more involved. Let’s start with the simple ones:

Purchase additional life insurance.

The death benefits paid out by a life insurance policy are not subject to PA inher­i­tance tax. And your heirs can use the benefits to pay for some or all the inher­i­tance tax bill. If you qualify for additional life insurance and it fits your budget, this is an easy way to provide liquidity to your estate.

Gift assets to your children or a charity.

Giving your assets away before you die removes them from your taxable estate. If you go this route, just make sure you stay within the federal gifting limit. For 2022, the amount is $16,000 per individual. Also be aware that any gifts made within 12 months of your passing will be brought back into the estate for inher­i­tance tax purposes.

Set up joint accounts with your heirs.

Pennsyl­vania only taxes the percentage of your assets that are solely owned by you. So, if you own a joint account with one of your adult children, only half the account will be subject to inher­i­tance tax. If you set up an account with three of your children, only one quarter of the account will be subject to the tax.

Okay, now let’s move on to the more involved strategies:

Move to another state (!).

There are 44 states that don’t require inher­i­tance tax. It’s worth mentioning that moving to one of these states is obviously one way to take care of the issue. But it’s of course a major under­taking and will only make sense for a small number of people.

Set up a trust.

Estab­lishing a trust such as a GRAT(Grantor Retained Annuity Trust)/CRAT (Chari­table Remainder Annuity Trust) or GRUT (Grantor Retained Unitrust)/CRUT (Chari­table Remainder Unitrust), which pays an annuity back to you and gives the excess to your heirs or a charity, could help reduce inher­i­tance tax. You’ll first want to seek legal counsel to determine if the assets you’d place in the trust are subject to PA inher­i­tance tax or not. The rules differ depending on how a trust is written. Generally, according to PA tax rules, revocable trust assets are 100% inheritance-taxable while irrev­o­cable trust assets are excluded from inher­i­tance tax.

Invest in farmland or a small family business.

The PA legis­lature has carved out inher­i­tance tax excep­tions for certain kinds of property. Farmland is one of them, if the land is inherited by family and continues to be used for agriculture for seven years. Small family-owned businesses (those with fewer than 50 employees and assets valued under $5 million) can also be exempt from inher­i­tance tax. The business must be in existence for at least five years, be inherited by family members, and stay in operation for another seven years.

Preparing for future inher­i­tance tax bills can seem simple but often ends up being compli­cated. When consid­ering one or more of these changes, it’s always a good idea to seek advice from your individual adviser.