If you choose to retire in a state with income tax, we believe Pennsylvania is about as good as it gets. That’s because, while the state still taxes interest and capital gains, pensions, IRA distributions, and social security are all exempt from its 3.07% income tax. The one downside (and it’s more of a downside for heirs) is that PA has an inheritance tax.
Inheritance tax is similar to estate tax, in that both systems tax your estate. Inheritance tax is levied on the heir, and the rate is determined by their relationship to the person who died. Estate tax, on the other hand, is levied on the estate, and the rate is determined by the value of the assets.
In Pennsylvania, inheritance tax doesn’t apply to everyone. Much like with federal estate tax, any transfers to spouses upon death are exempt from the tax. Additionally, transfers to children age 21 or younger, to charitable organizations, and to government entities are exempt as well. Also worth noting: Pennsylvania doesn’t include life insurance in your taxable gross estate (although it is included for federal estate tax purposes).
For transfers to your “lineal heirs,” which is tax-speak for your kids (both natural and adopted), stepchildren, parents, and grandparents, the inheritance tax rate is 4.5%. For transfers to a sibling, the rate is 12%. And for transfers to anyone else, it’s 15%. That includes cousins, nephews, nieces, friends, and anyone else you leave money to who doesn’t fall into the sibling or lineal categories.
Many people fear federal estate tax, which can be as high as 40%, but that tax only kicks in once the value of the estate exceeds $13.61 million. Additionally, since the advent of “portability”—a provision that allows a surviving spouse to combine the deceased spouse’s exemption with their own—very few estates are subject to federal estate tax (assuming proper planning has been done).
What Pennsylvania residents should be more concerned about is that, unlike with federal estate tax and the generous $13.61M exemption, every dollar you die with in PA is subject to inheritance tax. In fact, if you’re passing money to your kids and don’t elect portability (indicating an exemption of $13.61M rather than a $27.22M) your estate will need to be worth around $15.36M for the federal estate tax to exceed the Pennsylvania inheritance tax.
In other words, if you leave a $1M estate to your kids, you wouldn’t owe any federal estate tax, but your heirs would owe approximately $45,000 in inheritance tax to Pennsylvania. That makes lifetime giving particularly attractive to PA residents looking to minimize their tax bill.
This is particularly true if you’re planning to leave money to a sibling rather than a child (since the inheritance would be taxed at 12% instead of 4.5%). If you know you won’t need the money during your lifetime and you’re already planning to give your brother $10,000, consider doing it while you’re still living. You’ll avoid the $1,200 tax bill (and maybe he’ll pick up the tab next time you’re out for dinner!).
There’s one caveat: Pennsylvania has a one-year lookback, which means anything you give away during the 12 months prior to your death gets added back to the value of your estate. This prevents individuals from signing everything over on their deathbed just to avoid paying taxes.
Inheritance tax applies when the decedent was a resident of Pennsylvania. It also applies if they lived out of state but owned property in PA. When that’s the case, only the value of their Pennsylvania assets is subject to inheritance tax. And when an heir living in Pennsylvania inherits money from someone residing out of state, there’s no additional Pennsylvania taxes associated with the transfer.
The tax is due within nine months of the date of death, and if you pay within three months, the state grants a 5% discount on the tax.
In sum, while the federal estate tax (in its current form) is likely something very few people will need to worry about, Pennsylvania’s inheritance tax is something all state residents will want to consider.
