A guide to inheritance tax
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.
How does inheritance tax work?
When you die, 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
- Business interests and investments
Inheritance tax is then calculated and paid on your estate, which is what's left once your debts are subtracted from your assets. Depending on the value of your assets, you may be required to pay inheritance tax.
How much is inheritance tax?
Inheritance tax is currently charged at 40% on anything above £325,000 (the current threshold). IHT thresholds and rates for 2019-20 are currently fixed, with the threshold secured until at least the tax year 2020/21.
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. 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 inheritance tax is payable, there are various forms that need to be completed in the event of a death. The Government's website has more on all the forms associated with inheritance tax.
Who pays inheritance tax?
Everyone is subject to inheritance tax, but paying for it depends on the value of your estate. As mentioned previously, the current threshold for paying inheritance tax is an estate valuing at over £325,000. If your estate is valued below £325,000, you will pay no inheritance tax.
Leaving your estate to your spouse or civil partner is also a way to minimise your taxable estate. You’re able to leave an estate to a widow/widower worth up to £650,000 tax-free.
If your estate exceeds £325,000 in value, you’ll be required to pay 40% on anything above that threshold. While there’s no way to avoid paying this tax entirely, there are a few ways to reduce the cost:
- Charitable donation – leaving 10% of your estate to a charity in your will reduces inheritance tax from 40% to 36%.
- Residence Nil Rate Band (RNRB) – if you are leaving a property, defined as a ‘main residence’ (one in which you have lived in), to a direct descendent, you are entitled to an RNRB allowance. For 2019/20, this is £150,000 per person, while for 2020/21 it rises to £175,000. This balance is applied in addition to the standard inheritance tax threshold, which currently stands at £325,000. Therefore, by 2020/21, your combined threshold would reach £500,000.
- Passing on your threshold – married couples, or those in a civil partnership, can pass any unused threshold to their partner when they die.
- Business relief – a person’s business ownership will fall under their estate’s value, and is therefore subject to inheritance tax. Depending on the business circumstance, there’s potential to receive up to 100% business relief.
Why do we have to pay inheritance tax?
Many people question why they are effectively being taxed twice on their assets. Once while earning them throughout their life, and then a second time when they die. It was introduced on the idea of redistributing wealth for the benefit of the general public. So, rather than the rich getting exponentially richer through large inheritances, a portion of their wealth is redistributed to the public through taxation.
When do you pay inheritance tax?
You will be expected to pay inheritance tax 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 predominantly made up of property, there are ways to pay off the tax, in instalments, over a 10-year period. It’s important to note that this form of payment normally incurs interest charges.
How does inheritance tax work for married couples?
Married couples still need to think about inheritance tax, but there are benefits for you and your spouse or civil partner.
When you die, assets left to your partner are excluded from inheritance tax, allowing you to leave everything to them, tax free, if you wish. What’s more, married couples, or those in a civil partnership, can pass any unused IHT threshold (up to £3250,000), as well as any RNRB (up to £150,000), to their partner when they die. Therefore, by the time the second of you dies, they potentially have a threshold as high as £950,000 to pass on to others. This is scheduled to rise to £1,000,000 by 2020/21.
How does IHT work if I am not married?
Unmarried couples don’t receive the same benefits as married ones, or those in a civil partnership.
Firstly, if you don’t list your partner as a beneficiary in your will, they won’t immediately inherit any of the estate that isn’t jointly owned. Therefore, you should prioritise writing wills for each other, otherwise you may have to go to court to make a claim on the estate.
However, even if you are listed in each other’s wills, unmarried couples aren’t exempt from paying inheritance tax. Any unused nil rate band amount is also lost upon the first partner’s death.
When inheriting property, there is an important distinction between ‘joint tenants’ and ‘tenants in common’:
- Joint tenants – partners who own the property entirely. If you leave them everything in your will, the property will be passed to them in its entirety. Any assets which exceed the IHT threshold will still be subject to inheritance tax.
- Tenants in common – partners own a set share of the property. This can be equal or a specified percentage. When one of you dies, they can leave their share of the property to another family member, such as a child, while the other continues to live in the property.
How to reduce IHT when not married
While getting married, or entering a civil partnership, is the easiest way of avoiding greater inheritance tax impact, there are a few things you can do to reduce the tax 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 lie solely with the other, which will then no longer be subject to the deceased’s estate and inheritance tax threshold. This is a good way to protect your joint assets.
- Gifting your assets to others – simply giving your assets to your friends and family is a good way of avoiding inheritance tax. However, it isn’t as simple as you’d think. There are several rules associated with gifting. 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.
Giving a gift and inheritance tax
Unfortunately, you can’t just give your money away and avoid an inheritance tax charge entirely. There is a seven-year rule, by which, any money you give away is still classed as part of your estate. If you should die within seven years of giving the gift, the receiver will be subjected to inheritance tax. After the seven-year period ends, the gift is entirely theirs. Therefore, it’s important to plan appropriately, if you’re considering giving your assets away.
You also need to consider the rules on the amount you’re able to gift. There is a limit of £3,000 per year that you can give away as a gift. You can carry this limit forward into the next year, but not into a third. This £3,000 is excluded from any inheritance taxing.
While there is a £3,000 limit per year, there is also a £250 limit per person. Gifts of £250 per person are exempt from inheritance taxing. 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 receivers will be subject to standard inheritance tax rules.
Gifts to charities and other organisations are entirely inheritance tax free.
How is the estate valued for IHT?
There are three key steps to valuing a dead person’s estate. This process can take several months, and includes:
- Reaching out to organisations – you will need to contact the organisations in which the deceased had dealings with. This can include banks, loan companies, mortgage lenders, insurance providers, utility providers and more. You may need to provide a death certificate, alongside your request for information regarding their asset values and debts.
- Valuing assets - once you have this information, you must also receive values for their 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 – now that you have the total values totalled for the estate, you must inform the HMRC and advise them of the estate’s worth. Then, inheritance tax can be calculated.
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 allowance
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 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 die.
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.
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.