Should you be worried about death taxes?

Many Pennsylvania seniors share similar financial and estate planning concerns and goals. We want to be sure that we have enough resources to provide for our needs during our lifetime. And we want to pass a little something – as much as possible really – on to our families after our deaths.

For most of us, death taxes are a nuisance, but won’t prevent us from reaching these planning goals. Death taxes don’t affect our lifetime financial security because they only come into play when we die.  And with proper planning they won’t affect the financial security of our spouse because in most cases there is no tax on what we leave to our surviving husband or wife.

For most of us death taxes hit our families only when both spouses are gone and our home and savings pass to our children or other heirs.  At that point, they usually do take a bite.

Here is my simplified overview of how death taxes apply for Pennsylvania residents.   [The following information is based on the tax laws as they exist in September 2020.]

Death taxes are imposed by two taxing authorities: state and federal.

Federal Transfer Taxes

The federal government imposes a set of taxes (estate, gift, and generation-skipping) on the transfer of wealth. Under current law few families are affected.

Generally, there is no tax on what you leave to your spouse or charity. And there is no tax on the first $11.58 million (in 2020) that passes to your other heirs. This means that a married couple can protect 23.16 million from the tax. These exclusions increase each year with inflation. There is the potential that the exclusion amounts could be reduced in the future, but they will still likely be more than most people require. If you are one of the few people who do have an estate over the exclusion limits you need to plan to avoid or limit federal transfer taxes. The tax rate is high – the federal estate tax is 40% on the excess – but that tax can be greatly reduced or eliminated by good advance estate planning.

While a 40% federal death tax is severe, it doesn’t affect many people. Fewer than 1% of all estates are subject to federal estate tax. For most of us, it is not a worry.  [Note, however, that the current estate tax structure is set to expire after 2025. In addition, nothing prevents future lawmakers from reducing the exemption amounts or increasing the tax rate.]

Pennsylvania Inheritance Tax

The Pennsylvania inheritance tax applies to the things that Pennsylvania residents leave to their children, grandchildren and other non-spouse heirs.  It will impact most Pennsylvania families.

Inheritance tax is imposed as a percentage of the value of a decedent’s estate transferred to beneficiaries whether the assets pass through probate or not. There is no bottom threshold – even small estates are subject to PA inheritance tax. The tax also applies to transfers made by a decedent within a year of death to the extent in excess of $3,000.  The tax rate varies depending on the relationship of the heir to the decedent.

With a few special exceptions the rates for Pennsylvania inheritance tax are as follows:

• –         0 percent on transfers to a surviving spouse, to a child age 21 or under from a parent, and to a parent from a child aged 21 or younger;
• –         4.5 percent on other transfers to direct descendants and lineal heirs (see below for definitions);
• –       12 percent on transfers to siblings; and
• –         15 percent on transfers to other heirs, except charitable organizations, exempt institutions and government entities exempt from tax.

“Direct descendants” include natural children of parents and their descendants (whether or not they have been adopted by others), adopted descendants and their descendants and step-descendants. “Lineal heirs” include grandfathers, grandmothers, fathers, mothers and their children. “Children” include natural children (whether or not they have been adopted by others), adopted children and step-children.

There are some inheritance tax exemptions written into the law. The proceeds of life insurance policies on the decedent’s life are not taxed, and special rules may apply to IRAs and other retirement plans. In addition, real estate and physical objects located in another state are not subject to Pennsylvania inheritance tax.

Certain farm land and other agricultural property may be exempt from Pennsylvania inheritance tax, provided the property is transferred to eligible recipients. For more information about these agricultural exemptions and related requirements, see my earlier post: Pennsylvania eliminates tax on inheritance of family farms if law’s conditions are met.

Inheritance tax payments are due upon the death of the decedent and become delinquent nine months after the individual’s death. If inheritance tax is paid within three months of the decedent’s death, a 5 percent discount is allowed.

While the Pennsylvania inheritance tax can take a bite out of your estate, it is rarely devastating. Let’s say that when you die, your leave your home and investments to your children and that the net value of the inheritance is $300,000.  The PA inheritance tax would be 4 ½% of that, or $13,500, and the children would receive $286,500 in value.

If the $300,000 estate were left to a brother or sister the toll would be much higher. The PA inheritance tax would be 12% of that, or $36,000.

[This posting is an update of an article I originally posted on April 8, 2018.]