Updated: Dec 15, 2021
You work hard for your money. I have yet to meet a client who is not interested in reducing or avoiding every type of tax. That’s true, especially for inheritance taxes. People love to beat the taxman. Estate planning is an excellent way to engage in some tax planning and pass more of your hard-earned estate to your family. Just about every strategy to reduce or avoid inheritance tax comes with drawbacks. Let’s review the basics of inheritance tax and some tax avoidance strategies. I’ll give you a quick pro and con for each of those strategies.
What is Inheritance Tax
Pennsylvania inheritance tax is technically a tax on a beneficiary’s right to receive a deceased person’s property. It is assessed on most assets, regardless of whether probate is necessary or not. It is assessed against assets that pass pursuant to a Will and when the deceased person passed away without a Will (e.g. the law of intestate succession). Tax is also due on assets that pass by virtue of a beneficiary designation on an account (such as an IRA or 401(k) plan). Basically, when someone dies with assets, there is very likely inheritance tax due when those assets pass to a beneficiary.
The amount of tax a beneficiary pays depends on two things: 1) the value of the property they receive and 2) their relationship to the deceased person. Pennsylvania inheritance tax has four rates: 0% on assets passing to a surviving spouse, 4.5% to children and grandchildren. 12% to siblings and 15% to everyone else.
Ways to Reduce or Avoid Inheritance Tax
Here are some strategies for avoiding or reducing inheritance tax. I’ll describe the strategy and give you a quick pro and con relating to the strategy. This is not intended to be a complete description of everything that you should know about these strategies. One of the experienced estate planning attorneys at Fiffik Law Group and review your assets and family situation and help you make an informed decision on strategies that work best for you.
Give Your Assets Away
The most obvious strategy is to give away your assets. If you don’t own it when you pass away, the assets won’t be in your estate and will not be subject to inheritance tax.
Many people overlook this strategy, thinking that they’ll need to retain most of their money for their own care and comfort. In my experience, people assess their future needs without any professional input or analysis. A financial planner can be very helpful in assessing your future income, spending habits and likely needs for assets. You’ll have a better sense of what you’ll likely need and what you can give away to your family or a beloved charity. The real benefit here, in addition to reducing inheritance tax, is that you experience the joy of giving and gratitude of your family.
There are several downsides to this strategy, including giving away money that you might need for your own support in the future. A quick caveat – there is a one-year look-back period for any gift that you make. This means that assets you gift within one year of your death will be subject to inheritance tax. This rule avoids “deathbed” transfers to cheat the taxman out of his money. An additional downside is that you may have beneficiaries who are too young to receive and manage money (especially if they are under 18 years of age). You may also not want to give up control of how the money is managed. One way to mitigate these downsides is to create trusts and gift the money into those trusts. The money can be held and managed in the trust until after you pass away, deferring the beneficiary’s use and enjoyment until after you’re gone.
Title Assets Jointly
If you have an account, such as a bank account, that is jointly titled with someone else, you’ve engaged in a tax avoidance strategy. Its not uncommon for a parent to put a child on an account, usually to help with bill paying. What the bank teller usually does not tell the account owner is that by putting someone on your account, you are giving them ownership of one-half of the assets in your account. This gives the joint account holder many rights over the assets in the account but for purposes of this article, we’ll focus on the inheritance tax benefits.
If you named someone as a joint account owner more than a year prior to your death, inheritance tax will be payable on that portion of the account that you owned. That means if there are two owners, only fifty percent will be taxed. If there are three account owners, only one-third will be taxed.
When you own any asset jointly with another person, whether it’s a bank account or real estate, you are essentially “partners” in the asset. You may consider the asset yours to control because it was originally yours, but the law does not see it that way. Your co-owner can take and use the asset for themselves. If they have unpaid debts, the asset could be taken and sold by your co-owner’s creditor. Putting someone on your deed might even increase the taxes that are paid. Most people who create joint assets do so without a proper appreciation of these drawbacks to co-ownership.
Purchase Paid-Up Life Insurance
The death benefit of life insurance is not subject to inheritance tax. This is one of the very few assets exempt from tax in Pennsylvania. You might be wondering why we would include life insurance as a tax avoidance strategy. After all, most people think the primary purpose of life insurance is to provide a financial benefit to dependents upon the premature death of an insured person. Informed estate planners understand that life insurance can be a great tax avoidance tool as well.
Beneficiaries can get walloped by the Internal Revenue Service (IRS) when they inherit individual retirement accounts (IRAs), tax-deferred annuities and qualified retirement plans (like a 401(k)). They could end up losing up to $0.35 out of every dollar you leave them to federal income tax. This is not the case with life insurance. Also, life insurance guarantees that your heirs will get that money. This is in contrast to assets you have invested in the market, which goes up and down. Life insurance takes away the risks of the market and in return, gives you a guaranteed payout that is free of tax.
Life insurance is not a liquid asset. Once you purchase it, it’s not something easily undone. You would want to use discretionary money if you intend to pursue this strategy. Working with a financial planner is important with this strategy. They will be able to help you assess your future asset needs and identify what discretionary assets you have to purchase life insurance.
You can avoid or reduce inheritance taxes. There are pros and cons to every strategy. It’s important for you to understand them. The experienced estate planning attorneys at Fiffik Law Group can review your assets and family situation and suggest that’s right for you to maximize tax savings and minimize the downsides. Contact us or complete our easy estate planning questionnaire to get your estate planning started today.