Inheritance tax (IHT) is tax paid on the estate someone leaves behind when they pass away. With the right inheritance tax planning it is often possible to take full advantage of the exemptions and reliefs available to minimise inheritance tax bills that loved one pay.
In this guide, I explain more about Inheritance Tax, the main reliefs available and share some commonly used strategies when it comes to Inheritance Tax planning.
Table of contents
- 1. What is Inheritance Tax?
- 2. How Much is Inheritance Tax?
- 3. What is an Estate and How is the Value Worked Out?
- 4. Who Pays the IHT to HMRC?
- 5. IHT Reliefs and Exemptions
- 5.4 The Reduced Rate of Inheritance Tax
- 6. Inheritance Tax Planning Tips
- 7. Passing on Your Home
- 8. Key Takeaways
1. What is Inheritance Tax?
Inheritance tax is a tax paid on an estate when someone passes away. The principle 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 passed 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 these assets;
- Thirdly, the wealthier can afford tax planning specialists so can reduce the amounts of inheritance tax they eventually pay, managing to avoid the reason this tax was created in the first place.
2. How Much is Inheritance Tax?
IHT is paid on the value of estates exceeding £325,000. Below this threshold, there is no tax to pay (although details must still be reported to HMRC). And, although anything above this threshold is subject to tax, if your estate is being passed to your spouse, civil partner, a charity or a community amateur sports club, it will remain tax-free and outside the scope of IHT.
Your partner will also benefit from being able to add any unused tax-free threshold to their own, which means in the case of passing on your home, the tax-free threshold could become as much as £1m (more on that below).
The inheritance tax rate is currently 40%. So say the value of a total estate is £400,000, tax is paid on £75,000 (calculated as £400,000 minus £325,000).
3. 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;
- Cars and other vehicles;
- 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.
4. Who Pays the IHT to HMRC?
The funds from your estate are used to pay any IHT 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.
5. IHT Reliefs and Exemptions
Just like with many other UK taxes, reliefs and exemptions exist to reduce the amount of tax you have to pay in certain circumstances.
You are entitled to give away gifts tax-free (money, property and possessions) throughout your life as you wish. These are defined as small gifts and exempted gifts. Other types of gifts may still count towards the value of your estate, however.
5.1.1 Small Gifts
You can give away as many small gifts of up to £250 during a tax year and these will remain exempt from IHT, as long as you have not used another exemption on the same person. So that’s most likely things like Christmas presents and birthday presents.
5.1.2 Exempted Gifts
You can give away £3,000 worth of gifts every tax year without this affecting how your estate is valued for inheritance tax purposes, this is known as your ‘annual exemption’. You are allowed to carry forward any unused exemption for one year, so if you haven’t utilised your previous year’s annual exemption, you could be entitled to £6,000 this tax year.
You can also give away, tax-free:
- Wedding or civil ceremony gifts of up to £1,000 per person, increasing to £2,500 for a grandchild or great-grandchild and £5,000 for a child;
- Money to help with assistance for an elderly relative;
- Charitable and political donations.
5.2 The 7 Year Rule
Under this rule, gifts made more than 7 years before you pass away do not count as part of your estate. So if a parent, for example, chooses to ‘gift’ their family home onto their children while they are alive, it won’t be included in the value of the parents’ estate for inheritance tax purposes if the parent lives for more than 7 years after making the gift.
If you pass away within 7 years inheritance tax will become due, however, the tax rate applicable will be reduced from 40% depending on the number of years since the gift was made. This is known as taper relief and the current rates are:
|Years between gift and death
|Less than 3 years
|3 – 4 years
|4 – 5 years
|5 – 6 years
|6 – 7 years
|7 or more
5.3 The Increased Tax-Free Threshold
If you are passing on your own home to your children or grandchildren and your estate is worth less than £2 million, your tax-free threshold can increase to £500,000.
Jo passed away on 1 June 2020. She has no partner or spouse and is not entitled to any other allowances, exemptions or reliefs. She had made the following two gifts:
- Her home valued £400,000 to her daughter 6.5 years before her death;
- Cash of £75,000 to her friend 3.5 years before her death.
Her daughter will benefit from the £500,000 tax-free threshold first, increased because Jo gifted her home to her child. That means there is no IHT to pay
Her friend will pay tax at 32% on the full cash gift of £75,000, because the tax-free threshold has been fully utilised by Jo’s daughter.
5.4 The Reduced Rate of Inheritance Tax
There is a reduced rate of Inheritance Tax available of 36% on some assets if you leave 10% or more of the net value of your estate to charity in your will. HMRC has a calculator that you can use to estimate the IHT due at the reduced rate.
6. Inheritance Tax Planning Tips
It pays to plan when it comes to minimising the IHT bill your loved ones may face and mitigate the risks associated with them being hit with a large tax bill, expected or unexpcted.
6.1 Take Advantage of Gifts
You are entitled to give away £3,000 every tax year, without this being included in the value of your estate should you pass away. You can also bring forward this exemption from the previous tax year if you haven’t used it, meaning you could gift £6,000 in a single tax year. So don’t forget to take advantage of this tax-break year on year.
6.2 Use the 7 Year Rule
Depending on your age, passing assets like cash and property to your children sooner rather than later may mean they avoid paying IHT altogether.
6.3 Set up a Trust
Certain trusts can be set up which are useful for inheritance tax planning. The assets (cash or property for example) you wish to place in the trust will officially no longer belong to you, and therefore would not be included in your estate for inheritance tax when the time comes. There can be capital gains tax implications to setting up a trust and not all trusts avoid inheritance tax, so make sure you seek help from the right advisors if you fee this may be an option for you.
6.4 Charitable Donations
When you leave at least 10% of your estate to charity, inheritance tax is calculated on certain assets at 36% rather than 40%. Whilst your loved ones may have a reduced inheritance, making a charitable donation is always helpful and the reduced rate of inheritance tax is a tax saving.
6.5 Life Insurance
Although this doesn’t actually reduce the inheritance tax that needs to be paid from your estate, taking out a life insurance policy could mean that your family receive a lump sum in cash to help settle the tax bill and avoid having to make difficult decisions like selling the family home. The insurance payout will form part of your estate for inheritance tax purposes so get the right advice and make sure the payout is made into a trust to avoid inheritance tax on this lump sum.
7. Passing on Your Home
As property prices have increased, so too has the potential inheritance tax bill to pay when a property is passed from one generation to another. So unsurprisingly, people are looking at ways to avoid IHT, which can be substantial.
First of all, you can pass on your home to your partner when you die without paying any IHT. However, the problem arises when someone wants to pass their home to their children for example. The most popular way around IHT is to take advantage of the seven-year rule meaning you transfer ownership from yourself to the person you want to receive the property after you pass. To satisfy this rule though you don’t just need to transfer ownership, you must also:
- pay rent to the new owner at the market rental rate;
- pay your share of the bills;
- live there for at least 7 years.
You won’t need to pay rent if you only give away part of the property or the new owner(s) of the property live with you.
If these conditions are not met, your home could find itself being included within the estate value for inheritance tax purposes.
This type of transfer is generally exempt from Capital Gains Tax since it is your principal private residence. However, if you are trying to give a second property, then capital gains tax may arise as the property is in effect being sold. So always seek professional advice before you do this so you are fully aware of the implications.
It’s also worth remembering that on paper you will no longer own your home and lose all say around what happens to it. Unfortunately, any individuals situation can change and this includes your own children. A child could find themselves in the tricky situation of facing bankruptcy, putting your home at risk. Or perhaps, through no fault of their own, may need to divorce their partner, at which point your home could become a part of divorce discussions.
8. Key Takeaways
- Inheritance tax is a tax paid on the value of a persons estate;
- Estates left to an individuals partner are tax-free and not subject to the rules of IHT
- There is a tax-free threshold of £325,000 and this increases to £500,000 when leaving your home to your children in certain circumstances;
- The 7-year rule is one of the most common ways that individuals can transfer assets to their loved ones to avoid IHT because if they survive for 7 years after making the transfer, the asset will no longer be included in the value of the estate once they do pass away.