A guide to inheritance tax

With new rules on inheritance tax coming into force, it's a good time to understand some of the complexities in this tricky and emotional subject.

Kamran Altaf From the Life team
minute read

How does inheritance tax work?

When you pass away the Government needs to know the total value of your assets, and your liabilities (any outstanding debts you have). Your assets include:

  • Money in the bank
  • Property
  • Business interests and investments
  • Vehicles

Inheritance tax is paid on your estate, which is what's left once your debts are subtracted from your assets. Inheritance tax is currently charged at 40% on anything above £325,000 (the current threshold). This threshold has been fixed, at least, until the tax year 2020/21.

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So, let's say you left behind assets of £400,000. Your estate pays no tax on the first £325,000, but 40% is charged on the remaining £75,000. In this case, your estate would have to pay £30,000 in inheritance tax. 

Typically, there's no inheritance tax to pay if:

  • The value of your estate is below £325,000
  • You leave your estate to your spouse or civil partner (a widow or widower can pass on an estate worth up to £650,000 tax-free).

Regardless of whether or not inheritance tax is payable, there are various forms that need to be completed in the event of a loved one's passing away. The Government's website has more on all the forms associated with inheritance tax.

What else should I know about inheritance tax?

Two important things to consider about inheritance tax are:

  • The 'main residence' allowance
  • A new 'death tax' has been announced for April 2019 

The main residence allwoance

Introduced in April 2017, the main residence allowance means that couples can potentially leave property worth up to £1 million before paying any inheritance tax (depending on when they die, because this rule is being phased in gradually until 2020).

The main residence allowance is only valid on a main property when a home is passed on to a direct descendent. Only children, grandchildren and step-children can qualify. The way the rule works is – on top of your existing allowance of £325,000 – your descendants could get:

  • An extra £125,000 of tax-free allowance for 2018/19
  • A further £25,000 of additional allowance each tax year until 2020/21

Therefore, a personal total allowance of £500,000 could be reached by 2020/21 and for a couple that means £1,000,000. (£500,000 is the sum total of £325,000 added to the extra £125,000 this year; £25,000 the following year; and £25,000 the year after.)

A new ‘death tax’

New rules being introduced by the Government in April 2019 could result in higher probate fees being charged on estates. Probate fees are the costs associated with the access to, and distribution of, a person's estate when they pass away.

Currently, the fees for this process cost £155. But under the new plans, estates with a value of between £1 million and £1.6 million will have to pay £4,000 in probate fees, while those worth £2m or more would have to pay £6,000. It's anticipated that this would have a greater impact in London and the South East, and other areas where house prices have increased in recent years.

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So, can I avoid inheritance tax?

You can't avoid inheritance tax; neither can your estate. However, there are ways you can pay less than the full rate of inheritance tax. One way is by leaving at least 10% of your estate to a charity, as you'll pay a reduced inheritance tax rate of 36%, instead of 40%.

Another way to mitigate inheritance tax is by considering your options around life insurance. For example, by placing a life insurance policy 'in trust'. The pay-out from policies held in this way are kept separate from your estate. Read our guide to putting life insurance in trust for more information.

A whole of life policy (which can also be taken out in a trust) is another way to avoid some of the costs associated with inheritance tax. A tax-free lump sum pay-out, which is typically offered by this type of cover, makes it easier for your surviving family to pay a bill or carry on with mortgage payments. A good next step could be to start a detailed comparison of the different kinds of life insurance policies available.

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