A guide to inheritance tax
Inheritance tax is a tricky and emotional topic. Understand some of the complexities around the subject with our guide.
Inheritance tax is a tricky and emotional topic. Understand some of the complexities around the subject with our guide.
What is inheritance tax?
Inheritance tax (IHT) is a one-off tax paid on the value of the estate of someone who has died. The estate is made up of money, property and any other assets they owned. The tax is paid from the estate.
IHT doesn’t have to be paid on all estates. 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, civil partner or a charity or amateur sports club
If you are concerned about inheritance tax, or wonder if you need to pay it, please contact a tax advisor or solicitor.
How does inheritance tax work?
When someone dies, the government needs to know the total value of their assets, and their liabilities (any outstanding debts they have). Assets include:
- Money in the bank
- Business interests and investments
- Any insurance policies not in trust (includes death-in-service and some older pension schemes)
Inheritance tax is then calculated and, if applicable, paid from the estate, which is what’s left once debts are subtracted from the assets.
How much is inheritance tax?
Inheritance tax is currently charged at 40% on anything above £325,000 (the current IHT threshold). Anything below £325,000 is known as the nil rate band.
For example, 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. So in this case, your estate would have to pay £30,000 in inheritance tax.
Who pays inheritance tax?
If your estate exceeds £325,000 in value, the executor of the will must pay 40% on anything above that threshold.
Typically, the only way to avoid this is to leave your assets to your spouse or civil partner, or to a charity.
However, if you don’t do this, there are a few ways to reduce the cost:
- Charitable donation – leaving 10% of your estate to a charity in your will reduces your inheritance tax from 40% to 36%.
- Residence Nil Rate Band (RNRB) – if you’re leaving a property that’s defined as a ‘main residence’ (the property you lived in), to a direct descendant, you’re entitled to the RNRB allowance. For 2020/21, this is £175,000 per person. This is in addition to the IHT threshold of £325,000 – so your combined IHT threshold would be £500,000.
A direct descendent includes children and grandchildren, as well as step, adopted and foster children. Other family members, like siblings, cousins, nieces and nephews, are not included.
- Passing on your threshold – married couples, or civil partners, can pass any unused threshold to their partner when they die. So if none of the £325,000 threshold was used when the first partner in the couple died, the widow or widower could pass on an estate worth up to £650,000 tax-free.
- Business relief – if you own a business or have shares in one when you die, that will be considered part of your estate, so will be subject to inheritance tax. Depending on the circumstances, there’s potential to get up to 100% business relief. This can be passed on while the owner is still alive or as part of the will.
Why do we have to pay inheritance tax?
Many people question why they’re effectively being taxed twice on their assets – once when earning them, and then a second time when they die. The idea of inheritance tax is that it helps to redistribute wealth for the general good. So, rather than the rich getting exponentially richer through large inheritances, a portion of their wealth is redistributed to the public through tax.
When do you pay inheritance tax?
Inheritance tax must be paid within six months of the end of the month in which the person died. For example, if they died at any time in January, the inheritance tax must be paid by the end of July.
If an estate is mainly made up of property, there are ways to pay off the tax in instalments over a 10-year period, but this normally incurs interest. For 2020/21, the interest rate is set at 2.6%. If all the person’s assets have been sold, the tax must be paid in full.
How does inheritance tax work for married couples?
Married couples and civil partners still need to think about inheritance tax.
When you die, assets left to your partner are excluded from inheritance tax, so you can leave everything to them, tax free, if you want to. What’s more, married couples, or people in a civil partnership, can pass any unused IHT threshold, as well as any RNRB, to their partner when they die. So, by the time the second partner dies, they could potentially have a threshold as high as £1,000,000 to pass on to others.
|Inheritance tax threshold for partner one||£325,000|
|Residence nil rate band threshold for partner one||£175,000|
|Inheritance tax threshold for partner two||£325,000|
|Residence nil rate band threshold for partner two||£175,000|
If your husband, wife or civil partner died before the residence nil rate band was introduced, or before a rise in the inheritance tax threshold, you’ll still be entitled to today’s thresholds, as long as they passed all their assets on to you.
James and Emma are a married couple with two children. If James died first, he could pass all his assets to Emma, along with his £325,000 inheritance tax allowance and £175,000 residence nil rate band allowance for the home they share.
Emma, who has inherited James’ assets, keeps their home and other possessions, but has now effectively doubled her own allowances, taking her combined total, including James’ allowances, to £1,000,000.
This allows Emma to pass on up to £1,000,000 in assets, including the value of their home, to her two children when she dies.
But if James left assets to anyone besides Emma, his allowance would be impacted. For example, if James decided to leave £50,000 to his sister, then the unused inheritance tax threshold passed on to Emma would fall to £275,000. This would then leave her combined allowance at £950,000.
How does inheritance tax work for unmarried couples?
Unmarried couples don’t have the same IHT benefits as married ones, or those in a civil partnership.
Firstly, if you don’t name your partner as a beneficiary in your will, they won’t automatically inherit any of the estate that you don’t jointly own. You should each make a will leaving your assets to each other, otherwise the surviving partner may have to go to court to make a claim on the estate.
But even if you’re named in each other’s wills, unmarried couples aren’t exempt from inheritance tax. Any unused nil rate band amount is also lost when the first partner dies.
How to reduce inheritance tax when you’re not married
While getting married, or entering a civil partnership, is the easiest way to avoid IHT, there are a few things unmarried couples can do to reduce the taxable amount:
- Transferring assets – it may sound morbid, but if you know which of you is likely to outlive the other, you could transfer joint assets to the other partner. Those assets will then no longer be part of your estate and inheritance tax threshold.
- Gifting your assets – simply giving your assets to your partner –or your friends and family is a good way of avoiding inheritance tax. However, it isn’t as simple as you’d think. Money you give away is still classed as part of your estate, so it’s important to learn how to gift things properly to avoid an unpleasant surprise.
- Put your assets in trust – if your assets are in trust, they no longer make up part of your estate. For example, you could leave assets in a trust to your children, giving them access once they turn 18. Many trusts are still subject to inheritance tax rules, so you may be charged various fees, including entry, exit or rolling charges.
- Take out life insurance – this won’t reduce your inheritance tax bill, but it could cover the cost of the tax.
- Leave a portion of your estate to charity – if you leave a minimum of 10% of your estate to a charitable cause, the inheritance tax rate will be reduced from 40% to 36%.
Tenants in common and inheritance tax
When inheriting property that you owned with a person who has died, you don’t have to pay any stamp duty or tax in most cases. What you pay will depend on whether you were ‘joint tenants’ or ‘tenants in common’.
- Joint tenants (or ‘joint owners’ in Scotland) – partners who own the property entirely. The surviving partner will automatically inherit the property you owned together. Any assets that exceed the IHT threshold will still be subject to inheritance tax. This should come out of the deceased’s estate but, if it can’t pay it, you’ll have to.
- Tenants in common (or ‘common owners’ in Scotland and ‘coparceners’ in Northern Ireland) – partners own a set share of the property. This can be equal or a specified percentage. When one of you dies, one of you can leave your share of the property to another family member, like a child, while the other continues to live in the property.
If the deceased left you with a share of the property, or any other assets, the executor of the will or administrator of their estate should pay the IHT. If the estate doesn’t cover it, or the executive doesn’t pay, you’ll have to pay it.
Giving a gift and inheritance tax
Unfortunately, you can’t just give your money away and avoid an inheritance tax charge entirely – but if your gifting stays within certain rules you can reduce IHT.
The seven-year rule: any money you give away is classed as part of your estate. If you die within seven years of giving the gift, the recipient will be subject to inheritance tax.
But if you die after seven years have passed, the gift is no longer subject to inheritance tax. Gifts made between three and seven years before your death are taxed on a sliding scale. So it’s important to plan if you’re considering giving your assets away.
Gifts should also be made ‘without reservation’. This means that you have no investment in, or right to the gift once it’s given. An example of this is parents wanting to support their child with money for a house deposit. If the money is given without reservation, it means the parents have no stake in the house, despite helping pay for it.
The amount you gift: There’s a limit of £3,000 per year that you can give away as a gift without it being added to the value of your estate. You can carry this limit forward into the next year, but not any further. This £3,000 is known as your ‘annual exemption’ and is excluded from any inheritance tax.
While there is a £3,000 limit per year, there is also a £250 limit per person. Gifts of up to £250 per person are exempt from inheritance tax. With your £3,000 annual limit, split by the £250 per person limit, you can gift up to 12 people £250 per year. If you exceed these limits, the recipients will be subject to standard inheritance tax rules.
Gifts to charities and other organisations are entirely inheritance tax-free. You can also give away wedding gifts of up to £1,000 per person (£2,500 for a grandchild or great-grandchild, or £5,000 for a child).
How is an estate valued for inheritance tax?
There are three key steps to valuing a deceased person’s estate. This process can take several months, and includes:
- Reaching out to organisations – executors will need to contact any organisations the deceased had dealings with. This can include banks, loan companies, mortgage lenders, insurance providers, utility providers and more. They may need to provide a death certificate, plus requests for information about the value of their assets and their debts.
- Valuing assets – once the executor has this information, they must get values for the deceased’s physical property. This includes everything from their home, vehicles and jewellery, all the way to their furniture and other personal belongings. These values should be based on the item’s price on an open market. Gifts given away within seven years of death must also be considered.
- Reporting to HMRC – once the executor has the total values for the estate, they must inform HMRC so the inheritance tax can be calculated.
Will my heirs have to pay other taxes on their inheritance?
For your estate to be distributed to your heirs, inheritance tax and other debts must be paid first.
Your heirs may also need to pay:
- Income tax – if they inherit something that produces a regular income, like a business or rental property, your heirs may have to pay income tax charges.
- Capital gains tax – if your heir sells their inheritance for more than it was worth when you died, they’ll have to pay capital gains tax. The amount will depend on whether they’re a basic or higher rate tax payer.
What is the Residents Nil Rate Band allowance?
Introduced in April 2016, the Residents Nil Rate Band (RNRB) allowance means that couples can potentially leave property worth up to £1 million before paying any inheritance tax.
The RNRB is only valid when a main property is passed on to a direct descendant.
Only children (including adopted and foster children), grandchildren and stepchildren can qualify.
The way the rule works means that on top of your existing allowance of £325,000, your descendants could get an extra £175,000 of tax-free allowance for 2020/21.
Therefore, you could receive a total personal allowance of £500,000, which means couples could get a combined allowance of £1,000,000.
One thing to bear in mind is that the RNRB is capped at £175,000, or the value of equity in the property if it’s lower than that. So if you had £50,000 equity in the property, the allowance would be £50,000, not £175,000.
Is it possible to avoid inheritance tax?
You can't avoid inheritance tax; neither can your estate. However, there are ways you can reduce how much inheritance tax needs to be paid from your estate. One way is by leaving at least 10% of your estate to a charity, as this will reduce the inheritance tax rate to 36%, instead of 40%.
Another way to mitigate inheritance tax is by considering life insurance options, like placing a life insurance policy 'in trust'. The pay-out from policies held in this way is kept separate from your estate. For more information, read our guide to putting life insurance in trust.
A carefully structured life insurance plan, placed in trust, will provide your beneficiaries with money to cover IHT.
Unlike a mortgage policy or level term life insurance, these policies can be arranged to match the estate’s short and long-term liabilities, and pay out when they need to be paid. These policies will also cater for any changes in the law over the years.