What Is Inheritance Tax?
Inheritance Tax (IHT) is a topic that worries many people. The uncertainty of exactly what will happen to a person’s assets after they pass away is obviously a big concern. But not everyone needs to pay Inheritance Tax when they die as only a small percentage of estates are worth enough to incur a charge.
Here is our comprehensive guide on how Inheritance Tax is calculated, after reading you may realise you are liable to pay IHT and want to factor this into your will.
We aim to clarify some of the issues that may be concerning you, including how to work out what you will have to pay, when to pay it and a few ways in which you can reduce this tax.
Who Pays The Inheritance Tax
Funds are usually taken straight from your estate and paid to HM Revenue and Customs (HMRC). This is done by the person ‘executor’ of the will, presuming there is one rather than your beneficiaries having to pay tax on things they inherit. This is not to say that they won’t have related taxes to pay.
Sometimes the person who died has set aside money specifically to pay IHT. This can be done through a ‘whole-of-life insurance policy’.
Whole of life policy
- This policy lasts as long as you live, and matures when you die.
- Consider that you might be paying premiums well into old age. Premiums are generally more expensive the older you get though some whole-of-life plans charge a fixed premium so you know full costs at the outset.
- You might also find cover difficult to acquire as you get older, or have had health problems.
Term insurance policy
This kind of insurance policy allows you to gift assets to loved ones other than spouses when there is a risk that if you were to die within 7 years, a large tax bill would be received and owed by the receiver. Again, premiums are usually fixed at the start of the policy, which will be set to last a certain amount of time. The policy only pays out if you die within the stated period. After that period the policy expires.
It is true that payments from a life insurance policy could be subject to IHT, however, by writing the policy ‘in Trust’, IHT should be avoided. This could help to avoid the probate process.
Once IHT and liabilities have been paid, the executor or administrator can distribute the remaining estate.
How to value the estate
As mentioned above, the amount of Inheritance Tax you will pay is based on the value of your assets/estate (the total value of everything you possess) To value your estate you must:
- Compile a list of ALL assets along with their value at the time of death.
- Deduct from this any debts and liabilities.
You must make a record of how each asset was valued as HMRC can ask to see these records for up to 20 years after Inheritance Tax has been paid. This is important and easily overlooked. Also remember to keep records of how each valuation was made, such as estate agent’s/jewellers/ antique dealers valuation.
Assets can include items such as property, money in a bank, land, jewellery, vehicles, stocks and shares, and jointly owned assets. The Government website can give you a full list of what is classed as an asset. Gifts made within the seven years prior to death also need to be included. These could be cash or property; any other assets. You’ll also need to include any gifts given before this period if the person who died continued to benefit from the gift (such as living in a gifted house for example). These are known as ‘gifts with reservations of benefit’.
Debts and liabilities such as credit cards, household bills, mortgages and other loans) reduce the value of the estate, though any costs incurred after death, including solicitor/probate fees, cannot be deducted from the estate’s value (for IHT purposes).
Inheritance Tax Rates
The standard Inheritance Tax rate is 40%. This means you are charged 40% on the part of your estate that’s above the threshold.
For Example: Your estate is valued at £500,000 and your tax-free threshold is £325,000. This means you will be charged 40% of £175,000 (£500,000 minus £325,000).
If you leave 10% or more of the ‘net value’ of your estate to charity, a reduced rate of 36% will apply on some assets.
First of all, when you die, assets left to your spouse/civil partner, provided they live in the UK, are exempt from inheritance tax. Furthermore, your partner’s inheritance tax allowance will increase by the amount that you didn’t use, meaning together a married couple or a civil partnership can leave £900,000 without it being taxed.
There are other instances when inheritance tax is not charged. Some people in what are considered ‘risky’ roles are exempt from paying inheritance tax if their death occurs during active service. These roles include the armed forces personnel, police, firefighters and paramedics, plus humanitarian aid workers.
The exemption also applies if a person who was injured on active service has their death hastened by the injury, even if they’re no longer in active service.
- The value of your estate is below the £325,000 threshold (The nil band rate – NBR)
- You leave everything above the £325,000 limit to your spouse, civil partner, a charity or a community amateur sports club
Other factors to consider when calculating Inheritance Tax:
- If the estate is worth less than £325,000 you still need to report the persons passing away to HMRC.
- If you leave your home to your children (which includes adopted, foster or stepchildren) or your grandchildren, your threshold will increase to £475,000.
- If you are married or in a civil partnership and your estate is worth less than the threshold, any unused threshold can be added to your partner’s threshold when you die. Like a rollover. This means their threshold can be as much as £950,000. This extra transferable element is known as Transferable Nil Rate Band (TNRB).
Former Chancellor of the Exchequer George Osborne revealed in 2015 that he’d scrap the tax when parents or grandparents pass on a home worth up to £1 million, £500,000 for single people. This is fully effective from tax year 2020/21.
Some high value gifts you make while you’re alive could possibly be taxed after your death, depending on when you gave the gift. There’s also no Inheritance Tax to pay on gifts between spouses or civil partners whenever they may have occurred, however, gifts to other people will most likely count towards the value of your estate. Essentially, what this means is that Inheritance tax will be charged if you give away more than £325,000 in the 7 years before your death.
£3,000 worth of gifts can be given away each tax year (6 April to 5 April) without being considered as part of your estate. This is called your ‘annual exemption’. Any unused annual exemption can be carried forward to the next year, a rollover so to speak – but only for one year.
Each tax year, you can also give away:
- Wedding/civil ceremony gifts of up to £1,000 per person. £2,500 can be given to a grandchild or great-grandchild, £5,000 for a child
- Christmas or birthday presents providing this does not affect your standard of living
- Contributions towards another person’s living costs; child who is a student, carers for an elderly relative
- Gifts to charities and political parties
More than one of these exemptions can be used towards the same person.
If you make large gifts, the beneficiaries could take out life insurance against the potential impending inheritance tax bill. Most gifts into trust are now subject to inheritance tax even if made during your lifetime and you would need specialist advice in order to try and navigate your way around this. Smaller gifts of up to £250 per person can be given freely throughout the year as long as you have not used any other exemption on the same person.
Gifts made 3 to 7 years before your death are taxed on a sliding scale known as ‘taper relief’.‘Taper relief’ might mean the Inheritance Tax charged on the gift is less than 40%.
If your estate includes a farm or woodland you should contact the Inheritance Tax and probate helpline about Agricultural Relief.
You can get 100% Business Relief on a business or interest in a business or shares in an unlisted company.
You can get 50% Business Relief on:
- Shares in more than 50% of a listed company
- Land, buildings or machinery used in a business the deceased were a partner in or controlled
- Land, buildings or machinery of the business, held in a trust benefiting the deceased
The deceased must have owned the business or the assets for at least 2 years before they died for business relief to apply.
When is Inheritance Tax Paid?
The person or people who are acting as executors can choose to pay the tax on certain assets by instalment. These can be made over ten years but the amount that remains outstanding will get charged interest. If the asset is sold before all the IHT is paid, the executors must pay the balance owed at this point.
If your estate is to incur IHT, it is wise for your executor to pay as much as possible within the first six months of death, even if they haven’t finished valuing the estate, known as payment on account. This will limit the interest that could be charged.
If the executor or administrator is planning to pay the tax from their own account (maybe because assets have not been sold yet), they can claim it back from the estate. HMRC can always refund any overpayment once probate has been granted.
If you have been appointed executor or administrator of the estate you must complete and submit an account of the estate within a year of death to avoid penalties. An IHT reference number must be obtained at least three weeks before a payment is made. This can be done by post or online.