A guide to Inheritance Tax

We all want to pass on as much of our wealth as possible to our family and close friends when we die. However, on many estates that are left after death, there will be a certain amount of Inheritance Tax to pay. This won’t affect everyone, but a number of factors, including rising property prices across the UK, mean that more and more estates are falling into the category in which tax is payable.

Many people, quite understandably, want to minimise the amount of Inheritance Tax, or IHT for short, that is payable on their estate when the time comes and there are several ways to do this. This article aims show some of these as well as to explain IHT in general. But it’s a complex area so it could also be a good idea to talk to one of our wills and IHT experts at Eatons as well.

What is Inheritance Tax?

Inheritance Tax is a one-off tax that has to be paid to HMRC when a person dies and leaves an estate which is valued at over a certain amount of money. This level depends on a number of factors that we will go into shortly. But, just like income tax, there are certain thresholds under which no payment needs to be made.

In 2020 the tax raised around £5.32 billion for the UK Government so, although there has been considerable pressure to abolish IHT in the past, it looks like it’s here to stay. Besides the economic benefit to the country, another purpose has always been to limit inherited wealth and to prevent too much money being concentrated in a small proportion of the population.

Critics take issue with the fact that it effectively charges people for a second time on money and assets that they have already been taxed on once already. However, there are no signs that that there will be any changes in this particular tax law in the future.

The make-up of an estate

Inheritance Tax is charged on the deceased person’s estate, but there can be some confusion about what, exactly, this includes. Essentially, it consists of savings, property, investments and all personal possessions which even include furniture, cars, jewellery and anything else of monetary value. Any businesses owned by individuals will also count as part of their estate.

In certain circumstances, gifts made less than seven years before death can also be included in an estate, with the recipients of those gifts being liable to pay any Inheritance Tax that’s due.

In terms of valuing an estate, guide prices to what the items included would cost on the open market at the time of the person’s death are used.

Against the total value of an estate, all debts such as utility bills, outstanding mortgages and credit card balances which need to be settled are removed from the total amount.

How Inheritance Tax is calculated

Everyone has a personal Inheritance Tax allowance of £325,000. So, for estates that are worth less than this amount, there is no tax payable. Above this threshold, the flat rate of tax is 40%. So, for example, for someone leaving an estate worth a total of £500,000, the tax would only be payable on the £150,000 that falls above the threshold and the 40% tax would amount to £60,000.

Where one spouse or civil partner pre-deceases the other, any of their unused £325,000 IHT allowance is automatically passed on which can mean that their total threshold will be £650,000. In the same scenario as above in which the estate is worth £500,000 there would be no tax to pay. But if the total estate was £750,000 it would be payable on the £100,000 excess – leading to an IHT tax bill of £40,000.

The Residence Nil Rate Band Threshold

Because of rising property prices and the fact that, for most people, the most valuable asset they have to pass on is their home, in 2016 the government introduced the Residence Nil Rate Band Threshold.

This is an additional allowance that can be applied when a main residence is left to an immediate family member. At the moment this amounts up to an extra £175,000 on the standard threshold increasing it to a potential £500,000.

There are some restrictions that govern whether the RNRB applies and these are:

• It only applies when a property is left to a child (including adopted and foster children), a grandchild or a step-child.
• Only the main residence of the deceased can be included.
• £175,000 is the maximum allowance. If there is less than this amount in equity on the property then this amount will apply.

Ways to minimise the IHT payable

While these are the basic rules that govern how much IHT is payable, there are ways in which the amount can be minimised and, in some cases, eliminated altogether. As already mentioned, this has the potential to be a very complex area so seeking expert advice is essential - but these examples will give you a good idea about the sort of steps that can be taken.

• Leaving your entire estate to a spouse or civil partner

It has always been the law that any part of an estate left to a surviving husband, wife or civil partner is not liable to any IHT. By leaving everything to them it also means that the deceased’s £325,000 allowance will be passed on to make a £650,000 allowance. Add to this the potential additional amount of £350,000 created by the combined RNRB allowance, and a surviving spouse or partner could well end up with a £1,000,000 personal allowance to be used when the time comes.

One of the easiest ways to ensure that a partner does receive the whole estate is to write something called a mirror will. This simply includes instructions to an executor that an entire estate will be passed on to the other partner on behalf of the one who dies first.

• By giving to charity

Many charities rely heavily on bequests left in people’s wills for income. For most people who do choose to donate, they pick a cause that has helped them or a family member at some point in their lives, although animal and humanitarian charities such as the RSPCA and Amnesty international are also popular.

As well as contributing to a cause and helping them to continue with their vital work, a donation can also save money on IHT. This is because any estate that leaves at least 10% of its value, over the £325,000 allowance, to a charity will attract a reduced IHT rate of 36% regardless of all other bequests. To give an example of how this would work, if the total estate was £500,000, as long as at least 10% of the £175,000 on which IHT is payable is donated to charity, the IHT charge would be £63,000 compared with the £70,000 that would be payable at 40%.

• By making gifts

One very obvious way to minimise the amount of IHT payable on an estate is to make gifts while still alive.

Every single tax year, everyone has a £3,000 allowance that they are allowed to give away as gifts to anyone that they choose with an individual annual limit of £250 – so twelve people can potentially benefit each year. What’s more, any unused gifting allowance can be carried over to the next year, but not beyond that. So some years the allowance can be £6,000.

Wedding gifts of £1,000 a year are also allowed which rise to £5,000 for children and £2,500 for grandchildren and great-grandchildren. In all of these cases, this money will never be counted as part of an estate.

It’s also possible to make larger gifts than these, but if the donor dies withing seven years of them being made then IHT may be payable by the person who received the gift. The percentage payable is calculated on a sliding scale that rises in accordance with how soon before death the gift was awarded.

• Putting assets in trust

When assets are put in trust, they generally become free from IHT liability. So anyone wanting to leave significant amounts of money to children or grandchildren might want to go down this particular route. The downside is that once money or assets are in trust they can’t be removed from it but it does allow certain stipulations to be made. For example, many people who set up trusts make it a rule that the money or assets will not be available to their beneficiaries until they reach a certain age.

However, it’s important to remember that trusts will cost money to set up as there is quite a lot of legal work to be completed and there may also be entry, exit or rolling charges that need to be paid too.

• Take out a life insurance policy in trust

Just as many people chose to take out a life insurance policy as a way of covering funeral costs, the same principle can apply as a way to pay for IHT.

By taking out a life insurance policy in trust the money that it generates on death remains outside the estate and can cover all or part of the IHT costs. If this is going to be a preferred route then the earlier that a policy can be taken out, the better as premiums rise sharply as the applicant grows older.

• Equity release on a property

Much of many people’s wealth is tied up in their property so the only way to get their hands on it is by selling and buying somewhere that costs less. For those who don’t see this as and attractive option there are many equity release schemes available.

These involve either borrowing money against the value of the home or selling part of it at a reduced rate to the equity release provider and continuing to live in it.

This reduces IHT liability because both options use up some of the estate. But, before considering equity release as an option, it’s vital to receive expert advice as it has downsides that include the debt from the borrowing potentially becoming unmanageable if interest rates rise.

Inheritance Tax considerations for unmarried couples

Getting married or entering a civil partnership is the easiest way to avoid IHT. But for couples who are unmarried there are still some steps that they can take.

The first is to transfer joint assets like property to the other person as well as using the gifting methods described already. Similarly, setting up a trust will also protect against IHT.

In terms of property, it is important to be clear whether it is owned as joint tenants in which case it automatically passes in ownership to the surviving partner or as tenants in common. In the latter case, each partner owns a set proportion of the property so the surviving partner continues to own their share, while the deceased’s proportion can be left to their chosen beneficiary, whether or not it’s their unmarried partner.

It is also vital to specifically state in a will that a partner should be a beneficiary as they won’t automatically inherit any assets that aren’t jointly owned and this may involve having to go to court to make a claim.

Paying Inheritance Tax

Sorting out an estate can take some time for the executors of a will. In recognition of this, HMRC allows a time period of six months at the end of month in which the death occurred for the bill to be paid.

Because most estates involve property that may need more time to be sold in order to raise the money for payment, it’s also possible to pay off the IHT in instalments. This can stretch over a period of up to ten years, but it will involve also paying an interest at the current rate of 2.6%.

Before settling an IHT bill it’s essential to get a reference number from HMRC which should be requested at least three weeks before payment is due to be made.

Naturally, there is a great deal more to know about the ins and outs of Inheritance Tax requirements and planning and it’s an area where actions now can make a great deal of difference in the future.

So if you would like to know more on the subject, or ask for our help, please don’t hesitate to get in touch with us to arrange an initial meeting.

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