Pennsylvania: Good State for Retirement, Bad State for Death
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Pennsylvania: Good State To Retire In, Bad State To Die In

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.