“Inheritance tax” to some. “Death tax” to others. “IHT” to others still. Or even “Britain’s most hated tax” for those who’ve been slapped with an eye-watering bill from HMRC.
Love it or hate it, inheritance tax is a complex beast that’s affecting more and more families each year (£5.2 billion was paid in IHT in 2017/18 — up £400m from the previous tax year.) And anything with the word tax on the end is probably enough to make even the savviest of savers sweat a little.
But what exactly is it? Who does it apply to? And what might it mean for you?
For anyone new to the world of inheritance tax, or those that need to refresh their memory, we’re going to give you a whistle-stop tour of all the key elements you need to know. Think of it as inheritance tax 101.
Before we get started, though, it’s important to remember that the taxes you and your loved ones pay will depend on your individual situation – and that tax rules can change regularly. If in doubt, seek advice!
What is inheritance tax?
Inheritance tax is a tax on the estate (property, money or assets) of someone who has recently died.
How much is it?
If the estate left behind by an individual is valued at £325,000 or less (or £650,000 for married couples and civil partners), there won’t be any inheritance tax to pay. This threshold is known as the Nil-Rate Band.
Your spouse/civil partner will automatically inherit your personal nil-rate band, or what’s left unused, in the event of your death and vice versa.
Anything over the £325,000/£650,000 threshold will be subject to a 40% inheritance tax charge (36% if you leave over 10% of your total taxable estate, after all deductions, to charity).
So if someone was to leave an estate with a total value of £525,000, their beneficiaries would be taxed on anything over the nil-rate band (£325,000) i.e. £200,000. 40% of £200,000 makes £80,000 of inheritance tax to pay. So far, so simple.
Increasing your allowance
But there are a few other considerations at play which could help you keep more of your estate in the family.
The first is a relatively new allowance (effective as of 6 April 2017) that helps homeowners pass on more of their wealth — the catchily titled “Residence Nil-Rate Band” (more easily remembered as the main residence allowance).
This allows £150,000 of the value of your main home — or, again, double if you’re a couple (£300,000) — to be passed on free of inheritance tax. That’s in addition to the usual £325,000/£650,000 IHT allowance.
So effectively it’s a £150,000/£300,000 boost to your tax-free allowance, meaning the threshold could now start at £475,000 or £950,000.
There are, of course, some conditions. The most obvious one is that it must be your primary residence (or was at some point in the past) — it can’t be a buy-to-let property or holiday home. The other key requirement is that the estate is passed on to your children or grandchildren (including adopted and step) — not nieces, nephews, or even siblings.
You should also note that if your total estate is valued at more than £2m, you’ll lose £1 of the residence nil-rate band for every £2 over the threshold.
Getting a little complicated? Let’s take a look at a quick example:
John is single. He has an estate worth £2.1m — £150,000 in ISAs, £150,000 in savings, and a property worth £1.8m.
He can pass on £325,000 of his whole estate, tax-free, using up his personal nil-rate band.
He is also entitled to the additional residence nil-rate band of £150,000. But because he loses £1 of his allowance for every £2 over the £2m threshold, his total tax-free residence nil-rate band is capped at £100,000.
(To explain: John’s total estate is £100,000 over the £2m threshold. £100,000 divided by two is £50,000, which is subtracted from the £150,000 allowance, leaving him with £100,000.)
So that makes £425,000 that he can pass on tax free, leaving 40% tax to pay on the remainder (£1.675m) – a total bill of £670,000.
Who pays inheritance tax?
In short, it’s your beneficiaries who’ll have to foot the bill: those who your wealth is left to.
Practically speaking, though, if you’ve left a will, then the executor (the person named in the will to take care of the estate) is responsible for making arrangements to pay the inheritance tax bill.
But if you die without a will (what’s known as dying ‘intestate'), then it falls to the administrator of the estate — a person appointed by a court to manage it.
Typically, an inheritance tax bill is paid for from the estate being left behind, money gathered from selling assets, or through a Direct Payment Scheme (payments taken from a bank account left by the deceased).
But because the bill must be settled within 6 months of the person’s death to avoid interest, you can imagine the legal ordeal that might ensue for your dependants if you haven’t sorted your affairs out — they may have to sell property or take out a loan to cover the cost of IHT charges, all within a short time frame.
Planning for the unexpected
Failing to put a will in place during your lifetime could give your beneficiaries a headache (not to mention some heartache) when it comes to distributing your estate, as who gets what is out of your family’s control. Contrary to the common misconception, your estate isn’t automatically passed to your direct family members if you don’t leave a will.
Picture this — you’ve been in a relationship with your partner for over 30 years, living together in a home that you legally own. You’re unmarried and not in a civil partnership. If the unexpected were to happen, and you hadn’t left a will, your partner would be left with nothing; the home you shared together would instead be given to the state to decide what to do with.
And the devastating repercussions of not leaving a will can affect much more than your monetary assets — if you’re a parent and you haven’t named a legal guardian for your children in a will, they’ll be left in the care of the person the state chooses, not you.
Leaving a will, then, is a must. But, worryingly, 60% of UK adults don’t have one. If you’re among them, you might want to get round to it.
How could I reduce my inheritance tax bill?
While inheritance tax can be a daunting and complicated affair, it’s actually the only tax that you can entirely avoid; and with some careful planning, reducing your liability doesn’t have to be a nightmare.
From inheritance tax gifts, to reliefs and exemptions you may be eligible for, there are numerous avenues you can explore to make sure you pass on as much of your wealth as possible to your nearest and dearest.
Some of the simplest ways include:
- Gifting assets — you can gift as much as you want to your loved ones. Provided the gifts are made seven years before you pass away, they’ll be passed on entirely inheritance tax free. But, if you pass away within that time, they’ll fall within your estate – meaning it’s best to start planning early. There are also some smaller annual gifts you can make each tax year completely free from inheritance tax, such as £5,000 for a child’s wedding.
- Pensions — anything you’ve saved into a pension pot is excluded from your estate for IHT purposes. This means spending more of your other assets during your lifetime, and not dipping into your pension, could reduce your overall estate value and subsequently your IHT liability.
- Leaving your estate to your spouse/civil partner — anything you leave to a spouse or civil partner is exempt from inheritance tax, regardless of its value. Your spouse will also inherit your unused IHT allowance of up to £475,000 (their personal allowance and their main residence allowance) to add to their own (totalling £950,000).
- Making a will — if you want to make sure your wishes are carried out and your assets go to the right people, it’s imperative you make a will. You should also update it regularly in line with any changes to your situation or any new reliefs that come into force. Consider the residence nil-rate band — an out-of-date will that leaves your estate to your sibling means you won’t benefit from the additional £150,000 IHT free allowance (it has to be passed to a direct descendant).
- Placing assets into a trust — if you correctly place some of your estate into a trust, it won’t be included in the total value of your estate for inheritance tax purposes. Trust planning can often give you more control over how the money is used rather than just gifting it straight to your beneficiaries.
Trusts come in multiple flavours, depending on what your objective is, and can be used to do various things, like protecting family assets, paying for school fees or helping with future property purchases. Although trusts have many benefits, these come at the expense of flexibility — trusts are relatively sophisticated and can be difficult to access or change.
- Leaving money to charity – anything left to a charity is free from inheritance tax and, as mentioned above, if you leave over 10% of your taxable estate (after all reliefs are deducted) to charity, you’ll reduce the tax rate that’s payable from 40% to 36%.
- Taking out life insurance — if you take out a life insurance policy, you can instruct that a portion of the payout is to be used to cover your inheritance tax bill.
- Business Relief — if part of your estate includes a business or its assets, your beneficiaries will be able to apply for Business Relief (previously known as Business Property Relief). This can effectively reduce the value of the business by up to 100% in order to limit the amount of IHT that has to be paid on the estate.
And it’s not just business owners themselves who can benefit. There are solutions out there that allow everyday investors to pass on more of their estate by investing in businesses that qualify for Business Relief.
These investments can also become fully inheritance tax free within two years, rather than the usual seven associated with options like gifting, so can be attractive to those who’ve left their estate planning a bit late.
But they’ll invariably come with risks which you’ll want to carefully consider. For example, the value of your investment could fall as well as rise, and you may get back less than you put in. Your loss could be greater than the tax bill you’re trying to avoid.
The intricacies of inheritance tax payments can be a minefield to navigate, and it’s important to remember that while your beneficiaries might be saving on inheritance tax, they could end up paying more on income tax.
Don’t leave your estate to chance
Failing to plan for the future could have far reaching and expensive consequences.
And so when you’re dealing with something as important and complex as inheritance tax, it’s always best to get help from the experts. Unless you’re a tax whizz, chances are this is not something you want to DIY.
With the right guidance from a professional financial planner, you’ll have peace of mind knowing your estate is in safe hands, and that your beneficiaries won’t be surprised with a sizeable IHT bill when the time comes.
Want to find out more? Speak to one of our advisers today to find out how inheritance tax might affect you and your family. Tax rules change regularly, so if in doubt, seek advice!