A guide to inheritance tax
With inheritance tax a tricky and emotional topic, it’s good to understand some of the complexities around this subject.
With inheritance tax a tricky and emotional topic, it’s good to understand some of the complexities around this subject.
What is inheritance tax?
Inheritance tax is a one-off tax paid on the value of the estate of someone who has died. This includes money, property and any other assets they owned. The tax is paid from the estate, after any inheritance allowance is deducted, when someone dies.
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 paid from the estate, which is what's left once debts are subtracted from the assets. Depending on the value of the estate, it 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). Inheritance tax (IHT) thresholds and rates for 2020/21 are currently fixed.
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, there will be no inheritance tax due.
Leaving your estate to your spouse or civil partner is arguably the best way to minimise your taxable estate, as any assets left to them aren’t subject to inheritance tax. This allows you to share your capped allowance with other family members (such as your children) while leaving everything else to your spouse or civil partner.
If your estate exceeds £325,000 in value, your estate will 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 2020/21, this is £175,000 per person. This balance is applied in addition to the standard inheritance tax threshold, which currently stands at £325,000. Therefore, your combined threshold would reach £500,000. A direct descendant includes children and grandchildren, as well as step, adopted and foster children. Other family members, including siblings, cousins, nieces and nephews are not included.
- 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?
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 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, as well as any RNRB, to their partner when they die. Therefore, by the time the second of you dies, they 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|
James and Emma are a married couple with two children. If James died first, he could pass all of 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.
If James were to leave assets to anyone besides Emma, his allowance would be impacted. For example, if James decided to leave £50,000 to his sister Jane, 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.
If your spouse or civil partner died before the residence nil rate band was introduced, or before a rise in the inheritance tax threshold, you will still be entitled to today’s thresholds, as long as they passed all their assets on to you. Otherwise, you’d be subject to the usual deductions.
How does inheritance tax 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 inheritance tax. Any unused nil rate band amount is also lost upon the first partner’s death.
Tenants in common and inheritance tax
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 inheritance tax 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.
- Place your assets in trust – by placing your assets in trust, they will no longer make up part of your estate. For example, you could leave assets in a trust to your children, providing them access once they turn 18. However, many trusts are still subject to inheritance tax rules, so you may be charged various fees, including entry, exit or rolling periodic charges.
- Take out life insurance – while this won’t directly impact a potential inheritance tax bill, you can take out a life insurance policy which will cover the tax cost for your loved ones.
- 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%.
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 no longer classed as a ‘potentially exempt transfer’ and is no longer subject to inheritance tax. Therefore, it’s important to plan appropriately, if you’re considering giving your assets away. You should also ensure that your gift is made ‘without reservation’, which means that you have no investment or right to the gift once it’s given. This is most common for parents wanting to support their child with money for a house deposit. If made without reservation, it means that the parents have no stake in the house, despite helping pay for it.
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 inheritance tax?
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?
The Residents Nil Rate Band allowance
Introduced in April 2017, the Residents Nil Rate Band allowance means that couples can potentially leave property worth up to £1 million before paying any inheritance tax.
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 £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.
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 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 carefully structured life insurance plan, placed into trust, will provide your beneficiaries with funds to cover the tax liability. Unlike a mortgage policy or standard level term, these policies can be arranged to match the estate’s short and long term liabilities, and specifically pay out when the liability is triggered. These policies will also cater for any changes in legislation over the years.