Inheritance Tax: The Basics
Although it’s often in the news, inheritance tax is still not widely understood. That’s worrying, because it affects thousands of families every year.
If you thought inheritance tax was just for extremely wealthy people to worry about, think again. Rising property prices have meant more estates than ever are likely to face an inheritance tax bill. In fact, the amount of inheritance tax collected is expected to reach £6.9 billion by 2023-24, an increase of £1.5 billion in just five years.
If your estate has an inheritance tax liability, your beneficiaries will have to pay the inheritance tax bill. This may not be the kind of legacy most people think of leaving behind. The good news is that there are plenty of things you can do – in your lifetime – to take care of a potential inheritance tax problem.
Inheritance tax is paid on the value of the assets that a person leaves behind when they die. It can also apply to some gifts that are made before someone dies. When you die, your ‘estate’ is the assets you leave behind.
If you are married, or have a civil partner, then you can leave your entire estate to your spouse or partner free of inheritance tax. But if you want to leave some or all of your estate to family and friends, then it may be liable for inheritance tax.
Not everyone is required to pay inheritance tax
But if the value of your estate is worth more than £325,000 (known as the ‘nil-rate band’), then HMRC will expect you to pay inheritance tax at a rate of 40% on the total value of assets in your estate over that amount.
Your estate can include:
- Your house and any other properties you own.
- Any savings or investments (remember, some types of pensions are excluded from your estate, but other investments, including ISAs, are taxable).
- Any other assets.
- The value of any life insurance policies in your name.
How to work out what your estate is worth
After adding up all your assets, your next step should be to subtract any outstanding debts. These could include credit cards, loans and mortgages. You can also deduct the value of some gifts you make during your lifetime, charity donations left in your will and the reasonable costs of your funeral.
Note: You can reduce the rate of inheritance tax payable from 40% to 36% if you leave at least 10% of the value of your estate to charity. Donations made to charity upon your death are not subject to inheritance tax.
After calculating the potential value of your estate for inheritance tax purposes: Is the potential value of your estate less than £325,000?
Your estate isn’t facing an inheritance tax bill right now. However, it’s worth keeping an eye on the value of your assets, as any changes between now and when you die could mean an inheritance tax bill for some of the assets you leave behind.
Is the potential value of your estate more than £325,000?
Then your nil-rate band will be fully used up, and the remainder of your estate will be subject to inheritance tax.
How marital status affects inheritance tax
How the inheritance tax rules apply will differ depending on whether you are single, married or in a civil partnership.
Single
If you’re single and your estate is worth more than £325,000, anything over that amount will be liable for up to 40% inheritance tax.
Married/Civil Partnership
If you’re married or in a civil partnership, the assets you leave to your spouse will be transferred without any inheritance tax to pay. Also, leaving assets to a spouse does not use up your nil-rate band.
If you pass on any of your estate to someone other than your spouse or civil partner, and your estate is valued at more than £325,000, then the excess will be subject to up to 40% inheritance tax. The estate of your surviving spouse, now widowed, will be subject to inheritance tax as outlined below.
Widowed
When someone dies, their unused nil-rate band can be transferred to their spouse or civil partner. For example, if your spouse left everything to you before they died, you could potentially have a combined nil-rate band of £650,000 applied to the value of your estate.
Unmarried couple
If you are part of an unmarried couple, you are still treated as single for inheritance tax purposes. This means that each of you has a separate nil-rate band of £325,000 which cannot be combined upon death.
The residence nil-rate band
A new inheritance tax allowance was introduced in 2015. But the headlines that claimed it will give people a £1 million nil-rate band need closer scrutiny. Inheritance tax is a problem for homeowners.
After years of rising house prices, more people are now facing an inheritance tax liability on their estate, thanks to the increase in the value of their home. What’s more, the current nil-rate band of £325,000 for inheritance tax is expected to remain frozen until 2021.
In 2015, acknowledging the inheritance tax problem faced by large numbers of homeowners, the Government introduced an additional inheritance tax allowance of up to £175,000 to apply to the family home in certain circumstances. However, even with this, forecasts show that HMRC’s inheritance tax receipts are expected to continue to rise.
- The residence nil-rate band applies to the estates of people who die after 6 April 2017.
- You must plan on leaving a home to your children or grandchildren.
- The allowance was phased in and reached the maximum of £175,000 per person for deaths that occur after 6 April 2020 (£350,000 per couple).
- Adding this to a couple’s nil-rate band equals £1 million per couple.
- From April 2021, it will increase in line with inflation every year.
Who can claim the new allowance?
The intention is that married couples and civil partners can pass on assets worth £1 million, including the family home, without paying any inheritance tax at all. However, not everyone will benefit, and there are a few rules to be aware of:
- As the name suggests, this allowance will apply where the person who has died owned a property that was at one time their home.
- It will also only apply if the property is being left to the deceased’s direct descendants (children or grandchildren).
- It won’t help you if you don’t own a property. Also, anyone without direct descendants, or who wishes to leave their home to someone other than a direct descendant, cannot benefit.
- Anyone without a property worth at least £175,000 per person, or £350,000 per couple, will only partially benefit.
- The residence nil-rate band will be reduced by a rate of £1 for every £2 by which the estate exceeds £2 million. This means that larger estates may not benefit.
- Anyone who disposed of their property before 8 July 2015 – for example, because they are in residential care or living with their children – will not benefit from the new allowance at all.
What about spousal transfers?
The existing nil-rate band works so that if the first spouse or civil partner to pass away leaves their entire taxable estate to their surviving partner, then the estate of the second spouse can claim a total nil-rate band of £650,000 – double the individual nil-rate band. In a similar way, the estate of the second spouse or civil partner to pass away will be entitled to claim double the residence nil-rate band applicable in the year of the second death, where their partner’s estate did not make such a claim.
The maximum amount of the claim will still be limited to (a) the greater of the allowance at the time of the second death, and (b) the value of the home owned by the deceased. Although touted as a ‘million-pound inheritance tax allowance’, the number of clients who will be able to claim this level of exemption could be far fewer than originally anticipated.
Talk to your advisers about:
- Making a Will.
- Leaving pensions as part of your estate.
- Making gifts to reduce an estate’s value.
- Setting up a trust.
- Taking out life insurance to pay in inheritance tax.
- Investments in Business Property Relief (BPR) qualifying companies.
With early preparation and planning, you can achieve peace of mind confident that your loved ones will benefit from your legacy in a tax efficient manner. In conjunction with your solicitor, our financial advisers provide estate planning solutions that aim to preserve your assets. If you have any questions, our team is on hand to assist.
This article first appeared in the 5th issue of our Insights Magazine, which you can read by clicking here.