If you choose to retire to a state that has an income tax, we think Pennsylvania is about as good as it gets. This is because pensions, IRA distributions, and social security are all exempt from the state’s 3.07% income tax. While interest and capital gains are still taxable, let’s all be thankful for what we have.
The one downside, and it’s really more of a downside for your heirs than for you, is that Pennsylvania has an inheritance tax. At this point, you may be asking yourself, “What’s the difference between an inheritance tax and an estate tax?” The answer is: not much. Both systems tax your estate, but the rate of tax charged in an inheritance tax is determined by the heir’s relationship to the person that died. With an estate tax, the rate of tax is charged without respect to the heir’s relationship to the decedent, however there are exceptions to the tax that are based on the relationship of the heir to the person that died, most notably spouses.
Pennsylvania’s inheritance tax doesn’t apply to everyone. Much like the federal estate tax, any transfers at death to spouses are exempt from the tax. Additionally, transfers to children age 21 or younger, charitable organizations, and government entities are exempt from the tax. Also of note, Pennsylvania does not include life insurance in a person’s taxable gross estate, although it’s includable for federal estate tax purposes (unless proper estate planning has been completed to avoid that).
For transfers to your “lineal heirs” (which is tax-speak for your kids [both natural and adopted], step-kids, parents, and grandparents) there is a 4.5% inheritance tax. For transfers to a sibling, there’s a 12% inheritance tax. And for transfers to anyone else, there is a 15% inheritance tax. That includes cousins, nephews, nieces, friends, or any other person you were nice enough to leave money to who doesn’t fall into the other sibling or lineal heir category.
Many people are scared of the federal estate tax because they know that the rate can go as high as 40%, which sounds terrifying, but the tax only kicks in once the value of the estate exceeds $5.43 million. Additionally, since the advent of portability (a provision that allows the surviving spouse to combine the deceased spouse’s exemption amount with their own exemption amount [$5.43 million + $5.43 million = $10.86 million]) very few estates are subject to the federal estate tax, assuming that proper planning has been done.
What we think Pennsylvania residents should be more concerned by is that unlike the federal estate tax with its generous exemption amount of $5.43 million, every dollar you die with is subject to Pennsylvania’s inheritance tax. In fact, if you were passing money to your kids and didn’t elect portability (which would mean you only had a $5.43 million exemption rather than a $10.86 million exemption) you would need to have an estate worth about $6.12 million before the federal estate tax exceeded the Pennsylvania inheritance tax.
If you died with a $1,000,000 estate leaving it all to your kids, you wouldn’t owe any federal estate taxes but you would owe approximately $45,000 worth of inheritance taxes to Pennsylvania. That makes lifetime giving particularly attractive to Pennsylvania residents looking to minimize their tax bill. This is particularly true if you’re planning to leave money to a sibling rather than your children because their inheritance would be taxed at 12% rather than 4.5%. If you know you won’t have a need for the money during your lifetime and you were already planning to give your brother $10,000, consider doing it while you’re living so you can avoid the $1,200 tax bill. Plus then he might actually reach for the check next time you’re out for dinner! One caveat: for Pennsylvania, there is a one year lookback where anything you gave away 12 months prior to your death gets included back in the value of the estate. This prevents you from signing over everything you own on your deathbed just to avoid paying the tax.
The inheritance tax applies when the person that died was a resident of Pennsylvania. It would also apply if the decedent lived out of state but owned property in Pennsylvania. When that happens, only the value of their Pennsylvania assets are subject to the inheritance tax. If you live in Pennsylvania and inherit money from someone that resides outside of Pennsylvania, there would be no additional Pennsylvania taxes associated with the transfer.
The inheritance tax is due within nine months of the date of death. One nice incentive that the state gives you to pay earlier is a 5% discount on the tax due for paying within three months of the date of death.
While the federal estate tax (in its current form) is probably something that very few people will need to worry about, the inheritance tax is really something that all Pennsylvanians need to consider.