How does Inheritance Tax Work?

What is Inheritance Tax

What is Inheritance Tax?

Inheritance tax, put simply, is tax paid on an estate when someone passes away.   The principal behind this tax is to create a way of redistributing the wealth of the rich amongst the general population, rather than wealth remaining solely between a particular family or group of people.

There are several reasons why inheritance tax is so controversial today:

  • Firstly, an individual will have paid tax on their earnings used to buy their property or possessions they leave behind.  So taxing it when it is passes onto loved ones is considered a double tax;
  • Secondly, inheritance tax is a tax that doesn’t just affect the wealthy.  Many people have experienced huge increases in property value or have worked hard to pass some wealth to their children and know their loved ones may face a tax bill on receiving this;
  • Thirdly, the wealthier can afford tax planning specialists so can reduce the amounts of inheritance tax they eventually pay, stepping away from the reason this tax was created.

What is the Inheritance Tax Rate?

IHT is tax paid at 40% on the value of an estate over £325,000.

We are all entitled to pass an estate up to a certain amount, currently £325,000, without paying any inheritance tax.

However any value of your estate above this threshold is subject to inheritance tax.  So, if the value of the total estate is £400,000 tax is paid on £75,000 which is £400,000 less £325,000.

The standard current rate of Inheritance tax is charged at 40% on the value of the estate.

Note: There is a reduced rate available of 36% on some assets if you leave 10% or more of the ‘net value’ to charity in your will.

What is an estate and how is the value worked out?

Your estate is made up of money, property and possessions and, for inheritance tax purposes, any loans, credit card balances, overdrafts or mortgages will be deducted when reaching the value.

Typical possessions to include in an estate are:

  • Cash in a bank or building society account;
  • Property and land;
  • Personal belongings, such as jewellery;
  • Furniture;
  • Cars and other vehicles;
  • Shares;
  • Trusts (the trustees can help value the trust and determine whether an inheritance tax needs to be paid);
  • Non state pensions (the value of which can be determined by the provider);
  • Payouts from a life insurance policy;
  • Jointly owned property, bank accounts or other assets although the taxable portion will be included according to ownership or who put the money into the bank account.

Can I leave my estate to my spouse?

Yes, there is normally no tax to pay if you leave everything to your spouse or civil partner (there is also normally no tax to pay if you leave everything to a charity or a community amateur sports club).

Also if your estate is less than the threshold, currently £325,000, any unused amount of this threshold will be added to your spouses threshold.  For example: if the value of an estate passed to a civil partner is £300,000.  The unused threshold of £25,000 (£325,000 less £300,000) will  be added to the partners threshold.  Their threshold then becomes £350,000 (£325,000 plus £25,000).

Who Pays the Inheritance Tax to HMRC?

The funds from your estate are used to pay any Inheritance Tax and this is dealt with by the person dealing with the estate or the executor.

It normally needs to be paid within 6 months of the person passing away otherwise HMRC will begin charging interest.  However in the event that possessions need to be sold, such as property, HMRC can grant additional time to pay.

Unfortunately inheritance tax may be an unavoidable cost when passing on your estate to your loved ones. So always seek the help of a Professional to make sure the structure you choose is right for you and doesn’t leave anyone any nasty surprises.

Related: How to Avoid Inheritance Tax on Property