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Beyond the balance sheet

What is UK Inheritance Tax? Guidance on the thresholds and gifting

Tom Biggs 27/8/2021 15 minute read

Tom Biggs ACA CTA, describes how inheritance tax works and the strategies that can be implemented to help reduce it.

Double taxation!!!

The thoughts and exclamations of many when inheriting an estate in the UK, only to find there was a significant tax bill prior to handover. This is the perception many have when it comes to Inheritance Tax (IHT).

The thinking around it is that people acquire assets out of their income, which is taxed. They then hand over said assets in their estate, through their will, only for it to be taxed again in the form of IHT before being passed on to their beneficiaries.

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In effect, you pay the taxman on what you earn, only to then pay him again on everything you've acquired, out of said earnings, upon your passing. Doesn't sound very fair, does it? However, that may be a rather simplistic viewpoint.

The UK tax code is very large, subtle, and sophisticated, and IHT is a part of that. With the right knowledge and advice, there are various allowances and rules, around gifting, that could help reduce the size of your estate in order to cut your tax liability.

It's why we've written this post; to provide you with guidance and clarity, so that legally you can minimise how much of your estate you have to hand over to the taxman! By reading this you will understand how IHT works as well as the planning and strategies you need to consider:

What is Inheritance Tax?

IHT is a tax that's potentially applied if you're planning to pass on assets when you die. Broadly, your property, possessions, and money make up your estate, and this can be gifted to your spouse or civil partner free from taxation. If you're transferring your estate to other family members, or people, then you may be able to pass on some, most, or all of the assets tax-free, depending on your circumstances.

How much is IHT in the UK?

IHT is charged at 40% of your estate. However, there is a tax free allowance of £325,000, referred to as the nil-rate band (NRB).

To use a simple example, if you leave behind an estate worth £800,000 then this will generate a tax liability of £190,000, assuming no other reliefs or allowances are available. That's 40% of £475,000, which is the difference between the NRB and the total value of your estate. Of note, the NRB will remain fixed at £325,000 until 2026.

There are also various strategies that can be implemented, subject to your individual financial affairs, that can help either, reduce the size of your estate or, increase your NRB, to potentially cut the level of your exposure to taxation. These are explored in more detail, later in this post.

Who pays the IHT bill and when?

Usually, where you have a will there will be a nominated executor, that's the person responsible for the administration of your estate upon your death. This is known as probate. The funds generated from your estate are then used to pay the IHT bill to HMRC.

Depending on your affairs, your beneficiaries don't normally pay tax on the things they inherit from your estate. That said there may be IHT to pay tax on gifts received prior to your death. Additionally, income generated subsequently from assets your beneficiaries inherit is likely to be subject to income tax although this is not within the scope of this blog post.

Understanding the IHT nil-rate band

As mentioned earlier, the NRB is £325,000. This has been the case since the 2010/11 tax year. If however, you're married, or in a civil partnership, then you can effectively pool the allowances to double your NRB to £650,000 in certain circumstances.

How does IHT work on the value of your family home?

Your family home is treated slightly differently for IHT purposes so long as you're passing it to a lineal descendant, or a spouse/civil partner of a lineal descendant. This means you have to leave your home to your children, or grandchildren, or their spouse/civil partner. Nieces, nephews, and friends don't qualify as direct descendants. 

You get a main residence band which was phased in between 2017 and 2020. This potentially raises your NRB by £175,000 to £500,000, so long as at least £175,000 of the value of your estate is generated by your family home.

The main residence nil-rate band, or RNRB, can only apply to one home which has to be included in your estate. Your home can't be held in a trust. Also, to qualify as your home, you have to have lived in it at some point in your life, but not necessarily at the time of your death. Where you own more than 1 home that qualifies for the RNRB, then the executor of your estate can decide which home to use.

In the case of couples (where they own their own home), they effectively get a joint allowance meaning the RNRB can rise to £1m where £350,000 of that value comes from their home.

If your estate is valued above £2m, then for every £2 more than this value, you lose £1 of the RNRB. If your estate is worth £2.35m, then the benefit from the extra allowance is cancelled out.

How to calculate the size of your estate?

As mentioned earlier, IHT is usually due on estates worth more than £325,000. There are of course exceptions to this rule, which we cover in this post. To understand if the proceeds of your will are likely to incur an IHT liability, you need to put a value on your estate.

Start by listing everything you own, all your assets, and figure out how much they are worth. Think of things like:

  • Properties
  • Investments
  • Savings (including ISAs)
  • Debtors (money you're owed)

Where you own these things jointly with someone then it's a case of calculating your share. In instances where you're married, or in a civil partnership, the automatic assumption is a half share. Typically, things that are excluded from your estate include pension savings and life insurance policies. Pensions are covered in more detail later in this post.

Once you have calculated your total value, you then need to add up everything you owe, your liabilities. This is likely to consist of:

  • Mortgage borrowing
  • Personal loans
  • Credit card debt
  • Tax liabilities
  • Unpaid bills
  • Funeral expenses

Then you subtract everything you owe, from everything you own, to get to a net current value for your estate. You'll now be able to decipher if your estate exceeds the £325,000 NRB, or £500,000 if you own your home.

Dependent on your financial circumstances, the NRB for couples can get up to as much as £650,000, or even potentially £1m in the case of home ownership.

Note the words, "current value", remember that it's likely that as you age so the value of your assets, particularly your home and investments, are likely to rise while your liabilities will probably be paid off gradually, and hence decrease.

This means the value of your estate is likely therefore to increase over time, so you need to keep in mind that this could lead to greater tax exposure.

Transferable NRB - using the IHT allowance of your deceased husband or wife

Each individual has their own NRB, generally it's not possible to transfer your NRB to another person even if some, or all, of it is unused in death.

However, this is not the case for married couples and civil partnerships. In these instances the unused amount of NRB, or full amount if they did not use any of their tax allowance in their will, can be transferred to the surviving spouse, or civil partner, and they can later use that upon their own passing.

Of note this is only the case if the first spouse, or civil partner, that dies passes on all of their assets to the surviving spouse, or civil partner. Where that's the case, it can then potentially double the amount of NRB available to the surviving partner upon their passing. 

Inheritance Tax with subs

Gifting to reduce the size of your estate

One of the options to reduce the size of your estate and potential IHT bill is to give away, or gift your assets. This can help improve the finances of younger people, but requires planning ahead as gifts are categorised in 2 ways:

1. Those that are tax free immediately

2. Those that drop out of your estate after a period of time, typically 7 years

Gifts between spouses, civil partners, and gifts to charities are generally made free of IHT.

Before giving things away, you'll need consider what you'll need to live comfortably. This means only giving away what you can afford to lose. For example, it wouldn't be wise to risk retirement income, be sure also to factor in the potential for future care costs.  

Tax free gifting

Every tax year, you can make large gifts up to £3,000, and if you don't use this allowance then you can carry it forward to the next tax year.  You can also make as many smaller gifts as you wish, worth up to £250 per person. These are known as lifetime gifts.

Your gifts can be for a variety of things. Some options may include:

  • Grandchildren's education costs
  • Children's Junior ISAs
  • Deposits in a lifetime ISA to help relatives with the deposit on a first property
  • Wedding costs
  • Help fund further education

If you have children getting married then you can give gifts worth up to £5,000. For grandparents it's £2,500 and for other people £1,000. Of note, donations to political parties and charities can also be classified as tax free gifts.

Another interesting option is to give away surplus income that you don't need. The key to this is you need to demonstrate that you have more income than is necessary to maintain your current lifestyle. This means making regular gifts as part of your regular spending. Where that is the case you can gift as much superfluous income as you wish without IHT implications. 

Of note, IHT might not be payable on these lifetime gifts but some may result in a chargeable gain, resulting in a capital gains tax liability. This is why you need to consider tax advice, that takes into account all of your affairs, so that you don't get any unexpected tax bills.

What is the 7 year rule?

Gifts that don't meet the above, tax free gifting criteria, are classified as "potentially exempt transfers". They are potentially exempt because they will only not incur an IHT charge if you survive for at least 7 years after making the gift. If you pass away within the 7 years then the gift is subject to IHT.

Where a transfer becomes chargeable, its value is applied in a manner whereby it reduces your NRB and thus the amount you can pass on to your beneficiaries, tax free, on death. If you were to die within the 7 years and your gift exceeds the NRB of £325,000, then IHT will apply on the value exceeding the available NRB.

The exact amount of tax payable will depend on how long you survive after making the gift. The amount payable reduces over the lifetime of the 7 year period. This is known as the Taper. It works as follows:

Time since the gift was made Reduction in IHT
0 - 3 years None
3 - 4 years 20%
4 - 5 years 40%
5 - 6 years 60%
6 - 7 years 80%
7+ No charge

Of note, the rules can get very technical on the 7 year rule. If you continue to benefit from an asset after it has been gifted, then the gift may still be included as part of your estate. An example of this would be gifting your house, but continuing to live in it rent free. Furthermore there is a 14 year rule for gifts into certain types of trusts.

This all highlights the need to keep detailed records of what you gift and when, and in particular, the need for professional advice specific to your financial circumstances.

IHT and your pension

Private pensions can be a way of planning around IHT. This is because unused pension savings can be passed on to your heirs. Unfortunately, this isn't the case with defined-benefit pensions. If you die before you reach the age of 75 then there is no tax to pay. If you pass away after that age then your beneficiaries will pay income tax on what they receive.

Pension savings usually fall outside of what is considered for your estate and therefore IHT. This is why pensions should be considered when saving for later life. In doing this, you need to be mindful of the pension annual allowance of £40,000 per annum, and the lifetime allowance which stands currently at £1,073,100.

Do I have to inform HMRC if I inherit money?

Often, when you inherit something, there is no tax to pay immediately, but there might be a tax bill later on. That's because you may need to pay income tax on the profits that are generated from the asset you inherit, or capital gains tax, if you subsequently dispose of the asset. Think of things such as dividend income from shares, or rental income from an inherited property. 

If you received gifts, and IHT is found to be due on them, before the person gifting them to you passes away, then you'll likely have to pay the tax. If you're unable to pay the liability, then the bill will be applied to your estate.

Any income tax, or capital gains tax, arising from the assets you inherit needs to be declared on a tax return.

Why IHT could be set to rise

The Office for Budget Responsibility predicted that the COVID-19 pandemic could lead to a 20% increase in the number of families incurring IHT liabilities, due to the number of unexpected deaths. If they're unexpected, they're less likely to be planned for from an estate and tax perspective.

Then consider that the NRB has been frozen since 2010/11 tax year and, following the 2021 Budget, the NRB will remain at that level until 2025/26. House prices have been rising since 2010 and could well continue to go up. This means more families are likely to be exposed to IHT, and the receipts from this tax are likely to rise.

The Treasury expects to raise an extra £1bn from IHT over the next 5 years as a result of the freeze. This highlights the need to follow the guidance in this post, and to obtain professional advice so that planning can be devised around your circumstances to ensure your exposure to IHT is minimised where possible.

To add to this, the Organisation for Economic Co-Operation and Development (OECD) has recommended its 37 member states raise IHT to pay for all the spending and debt as a result of the COVID-19 pandemic. It noted that less than 1% of all tax revenues in the UK was generated through IHT.

This can be seen as part of an ever increasing movement to tax wealth. The OECD sees IHT as a useful tool in raising tax revenues should many asset prices, such as property, continue to rise. The report also favours reducing the number of exemptions.

With this in mind, make sure you have a good understanding of the current rules, and financially plan your retirement, and inheritance, around them.

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The content of this post was created on 27/08/2021.

Please be aware that information provided by this blog is subject to regular legal and regulatory change. We recommend that you do not take any information held within our website or guides (eBooks) as a definitive guide to the law on the relevant matter being discussed. We suggest your course of action should be to seek legal or professional advice where necessary rather than relying on the content supplied by the author(s) of this blog.

 

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