People can often be confused about the difference between the inheritance tax and the estate tax, and your clients may wonder what taxes Pennsylvanians have to pay. As the tax authority for your clients, you will want to demonstrate your knowledge while guiding them in making decisions to help them limit taxes where they can.
When someone dies and leaves assets to family or friends, the government often wants a piece of the pie. The estate tax is essentially a tax on the deceased – it is assessed upon the estate, and can be quite substantial. The inheritance tax, however, is paid by the heir, and the rate depends on the closeness of the relations between the deceased (called the decedent) and the beneficiaries.
Pennsylvania’s tax on estates
Pennsylvania does not have an estate tax, but it is one of six states that have an inheritance tax. Per the PA Department of Revenue, the current rates are as follows:
- 0% on transfers to a surviving spouse or to a parent from a child aged 21 or younger
- 4.5% on transfers to direct descendants, lineal heirs, and lineal ascendants (children, grandchildren, parents, grandparents, etc.); this includes spouses of children, grandchildren, etc.
- 12% on transfers to siblings
- 15% on transfers to other heirs, including nieces and nephews, friends, pets, and organizations, except charitable organizations, exempt institutions, and government entities exempt from tax
Keep in mind when advising your clients that domestic partners are not considered spouses or lineal heirs and therefore are charged at the 15% rate.
What about an IRA or 401(k)?
Retirement accounts like IRAs and 401(k) plans are generally subject to inheritance tax, but there are several exceptions.
- The decedent’s spouse will pay no inheritance tax on the IRA or 401(k).
- If the decedent dies before age 59½, in most circumstances the heirs will not pay inheritance tax.
- If the decedent was disabled at the time of death, the IRA or 401(k) is subject to inheritance tax, regardless of age.
How you can help your clients
Though there aren’t too many options once someone dies and leaves your clients an inheritance, your client does have a few options regarding their own assets that they will leave behind. Help them plan ahead.
Make sure your clients have clearly defined who the primary and secondary beneficiaries of their retirement funds are, especially if there has been any family upheaval such as divorce. Consider recommending converting an IRA into a Roth IRA. Your clients will have to pay taxes on the assets the year of the conversion, so this only works if they have plenty of funds. But the effect will be to decrease the cash they have on hand, thus decreasing inheritance taxes, while providing their children with a resource from which they can withdraw tax-free in the future.
Your clients can set up joint accounts with their heirs, if they fully trust the heirs will not dip into the funds. The beneficiaries will then only pay tax on their portion, not on yours as well. For instance, if a client has only one child and takes out a joint account with him or her, the child may receive the entire account when your client dies but will only pay inheritance tax on half of it. This, however, requires a very high level of trust.
Your clients can gift assets to their children. This should be carefully weighed against the tax effects for your client, for instance, in the case of capital gains or losses when gifting stocks.
Certain real estate purchases could benefit your clients. Working farmland is exempt from inheritance tax, as long as it remains a working farm for at least seven years after being inherited. Purchasing property outside of PA can also decrease inheritance tax, since PA only taxes property within its borders. However, your client should consider possible expenses or taxes in the other state when weighing this option.
Discuss the possibilities with your clients to see how you can best help them limit their inheritance tax.