I believe it is important for me to tell you about The 3 death taxes… The Good, the Bad and the Ugly, as it relates to middle-class Americans. There is no ‘good’ tax, but what is good is that the federal estate tax very likely doesn’t apply to you. The other two ‘death’ taxes are the Pennsylvania’s inheritance tax and The Secure Act.
What is Federal Estate Tax?
When people reach out to our law firm, they are concerned that when they pass away they have to pay federal estate tax. However, we don’t need to worry about federal estate tax, and we have a $12,9 million lifetime exemption from this tax as an individual. For a married couple, the limit is $26 million. Suffice to say, most middle-class Americans don’t have that kind of money, so we’re exempt from federal estate tax.
The ‘Bad’ Tax… Pennsylvania Inheritance Tax
There are about 22 US States where residents have to pay ‘death’ tax, and Pennsylvania is included. Also, Pennsylvania is one of six states paying inheritance tax, while the rest have estate taxes. Estate tax is technically owed by the estate, so if you pass away and stuff goes through your will, your executor must pay. The inheritance tax is technically owed by the person or people inheriting the money. They must pay the tax accordingly.
The Inheritance Tax Rates
The tax rate between spouses is 0%. There is also no tax if you leave your money to a nonprofit. Leaving money to lineal descendants, including kids, grandkids or even parents, incurs a tax rate of 4.5%. Regardless of where your family lives, if you pass away as a Pennsylvanian resident, your kids will pay Pennsylvania’s inheritance tax. This is because they are exercising the privilege of inheriting money from someone who died as a Pennsylvania resident.
If you don’t have children, and you want to leave the money to a sibling, the tax rate is 12%. Leaving assets to anybody else such as nieces or nephews, or friends, will incur 15% tax.
Assets that are Subject to Inheritance Tax
Almost all your assets, including investments are potentially subject to the inheritance tax. Your house and your car are subject to the tax too. There are a few minor exceptions, and one is that Pennsylvania does not tax life insurance proceeds. In addition, you won’t pay tax on the transfer of ‘out of state’ real estate. If you own a home in Florida, Pennsylvania doesn’t get tax on the transfer of that property.
Can you avoid paying Inheritance Tax?
Any step you take to avoid paying inheritance tax, could result in you having to pay capital gains tax. If I bought my house for $100,000 ten years ago, and today it is worth $300,000, it means there’s a $200,000 capital gain If I give the house to my kid, and he sells it. My kid will have to pay 18% capital gains tax, which is $36,000. He would only have to pay $9,000 inheritance tax, at a rate of 4.5% once I pass away. We often advise our clients to pay the inheritance tax to avoid paying capital gains tax.
Why You Should Pay Inheritance Tax
If your kid inherits the property when you pass away, he gets what is known as a stepped up tax basis. This means he doesn’t own the house for $100,000 which is what you bought it for. Your kid owns the house for a value of $300,000, and he is free to sell it for for $300,000 after you pass away, and there’s no capital gains tax due. It boils down to leaving the assets in your name until you pass away, which also means your kid must pay the inheritance tax.
The Secure Act is the ‘Ugly’ Tax
The Secure Act is essentially a giant income tax hike on middle-class Americans. It is a type of tax which is due within a defined time after somebody has passed away. This tax is due on retirement accounts. A kid of a retired school teacher who receives $600,000 in retirement accounts, has to pay tax on that money within 10 years. However, if he receives an inheritance of $12 million not in retirement accounts, he is not taxed.
The Secure Act eliminated the lifetime stretch on the retirement accounts, when kids inherit the accounts. Now when a child receives a $200,000 retirement account, he has to pull the money out over 10 years. He loses out on 30 years of tax deferred growth on the money. If he is around 50 years of age when he inherits the account, he is likely still working. He is not ready to retire, but he does not have the privilege of waiting until his retirement to take the money out. Instead, he has to take the money out between the age of 50 and 60, and pay ordinary income tax rates on dad’s IRA money. If he’s still working, he has to pay tax on his own income, so he ends up paying more tax. It hardly seems fair.
Allow Us To Share Our Three Secrets…
If you are concerned about any of this, come to one of our upcoming estate planning and elder law workshops, known as the Three Secrets Workshops, which are at no cost to you. Register for our workshops on our website: secherlawfirm.com/workshops. We host the workshops regularly, in both Cranberry and Southpointe. We look forward to meeting you there.