Inheritance Tax explained
Understanding Inheritance Tax
In its simplest terms, inheritance tax is a tax on the money or assets that a person leaves behind when they die. It can also apply to some gifts that are made before someone dies.
When an individual dies, the property, money and other assets that they leave behind (minus any debts that have to be paid off) is known as their ‘estate’. This estate is usually left to the friends and family of the person who has died and effectively becomes their inheritance. This is where inheritance tax (or IHT for short) comes in. Thanks to IHT the UK government is able to lay claim to a sizeable chunk of the value of an individual’s estate when he or she dies.
Of course, IHT is a tax that not everyone is required to pay. It’s only due if the deceased’s estate is valued over the current IHT threshold (£325,000 until 2015). The tax is payable at 40%* on the amount over this threshold. If the estate is valued below this threshold it falls within the nil rate band (NRB) and no IHT is payable. What this means is that an individual with an estate worth more than £325,000 will be required to pay IHT at a rate of 40% on anything above that level.
How to calculate your potential IHT
To see if your estate will be liable to IHT when you die, add up the value of everything you own in your name, or a share of anything owned jointly, including:
- Your house and any other properties you own
- Any savings or investments
- Other assets from which you receive an income
- The value of any life insurance policies in your name
Now deduct any debts, such as outstanding mortgage or loan, and anything you want to leave to charity. You can also deduct the value of any gifts made on death that are exempt from IHT (there are strict rules in place that govern whether gifts are exempt – you can read more about this in our guide) and the reasonable costs of your funeral.
John Smith dies leaving an estate (home and investments) = £500,000
Subtracting the NRB means £500,000–£325,000 = £175,000
(John Smith’s taxable estate)
John Smith’s estate will be taxed at a rate of 40%* = £70,000 IHT bill
(i.e. £175,000 x 40%)
* Since April 2012 the rate of IHT payable is reduced to 36% provided the deceased leaves 10% or more of their estate to charity.
An individual’s IHT liability is usually paid from their estate, so whatever is left over after all debts have been paid. In most cases, IHT must be paid within six months from the end of the month in which the death occurs. If not, interest is charged on the unpaid amount. Tax on some assets, including land and buildings, can be deferred and paid to HM Revenue & Customs in instalments over ten years. However, if the asset is sold before all the instalments have been paid, the outstanding amount must be paid in full.
If IHT is due on gifts made by the deceased in the last seven years before their death, those people who received the gifts must repay any IHT due. If they cannot or will not pay, the amount due then comes out of the deceased’s estate. There are strict rules in place that govern whether gifts are exempt – you can read more about this in our guide.
LEAVING ASSETS TO A SPOUSE OR CIVIL PARTNER
When it comes to IHT planning, the easiest option is to leave assets in your will to your spouse or civil partner. As a result, your spouse or civil partner will not have to face selling your home to pay for the tax and will have a double Nil Rate Band allowance (worth up to £650,000) when they die. Also, any gifts between spouses or civil partners are exempt from IHT, whether they were made while both parties were still living, or if they were left to the surviving spouse or civil partner upon death.
THE IMPORTANCE OF MAKING A WILL
Failing to leave a will when you die (known as dying ‘intestate’) can put a lot of stress and strain on the people left behind and your estate may not be passed on in line with your wishes. This is of particular concern for couples who are not married or not in a civil partnership. If you have no close relatives and die intestate then the government can end up with your assets. It’s therefore crucial to make a will, even if you want to ensure that your estate is left to your favourite charity. You can find out more about wills in our Will section. Click here.
GETTING HELP WITH IHT PLANNING
The good news is that, with the right financial planning, practically everyone with an IHT liability should be able to reduce or eliminate it, and pass on as much of their estate to their loved ones as possible. There are a number of different IHT planning solutions available, suiting a wide variety of people. Finding the right approach will depend on your individual circumstances and talking to a qualified investment adviser will help as they can explain the different options available.
WHERE TO GET HELP AND ADVICE
Planning what assets to leave, and to whom, can be complicated, so it’s important to get professional advice from a solicitor, tax adviser or independent financial adviser. Click here
One way to lessen a potential IHT bill is to simply ‘gift’ your assets away. However, there are some pitfalls that you need to be wary of.
HM Revenue & Customs allows individuals to gift up to a total value of £3,000 a year (known as the annual exemption). If you do not use your £3,000 total in one year you can ‘carry over’ the remainder and add it to the next year’s annual exemption, although you can only do this for one year.
Individuals can make as many small gifts as they wish, as long as the total given to any one person is no more than £250 in any one year. You cannot use your annual exemption and your small gift exemption on the same person in any one year.
GIFTS TO FAMILY
Any gifts between spouses or civil partners are free from IHT. HM Revenue & Customs also allows individuals to make wedding gifts free of IHT, up to a limit of £5,000 for each son or daughter, £2,500 for each grandchild and £1,000 for anyone else. Gifts made to children who are not relatives remain exempt as long as they are in full-time education. Regular gifts from after-tax income, such as a monthly payment to a family member, are also exempt as long as the giver still has sufficient income to maintain their standard of living.
IHT will not be paid on gifts made to charities, national museums, universities, the National Trust, political parties and some other institutions such as housing associations.
Any assets that you give away will fall outside of your taxable estate seven years after the gift was made. However, if a person dies within this seven year period, the full value of the gifts will still be included in the final IHT bill. It’s worth noting that the rate of IHT due reduces if the donor survives between three and seven years (this is know as taper relief).
DO I NEED TO KEEP RECORDS OF GIFTS?
Although there is no formal obligation to keep records of gifts that you make while you are alive (whether they are IHT exempt or not), the executors of your estate are obliged to discover them all and to make sure the correct IHT is paid. So, it would be very helpful to your executors – who will normally be your heirs – to keep a note of any gifts that you make. If you think they are exempt gifts then explain why. Keep these documents with your will or other papers so that they are easily found.
Another good reason to keep detailed records is that everything that makes up the estate left by a spouse or civil partner will be taken into account when calculating the allowance on the second spouse’s or civil partner’s estate.
People use trusts to help ensure that assets can be given to beneficiaries but in a timely and controlled manner, and without incurring an IHT bill.
WHY USE A TRUST?
A trust can be used by someone who wants to make a gift to a third party (known as the beneficiary). For example, many people set up trusts so that part of their estate goes directly to their grandchildren when they die. The trust can be designed to make sure that assets remain in place until the beneficiaries reach a certain age, usually 18 or older. There are several different types of trust available, some examples are below.
BARE TRUSTS, OR ABSOLUTE TRUSTS
With a bare trust, the beneficiaries are entitled to all of the assets that are held within the trust. The main duty of the trustees (the people appointed to manage the trust) is to manage the assets for the beneficiaries and to transfer the assets when required.
INTEREST IN POSSESSION TRUSTS
An interest in possession trust is one where the beneficiary of a trust has an immediate and automatic right to the income from the trust as it arises. The trustees must pass all of the income received, less any trustees’ expenses, to the beneficiary. The beneficiary who receives the income often doesn’t have any rights over the capital of such a trust. Instead the capital will normally pass to a different beneficiary or beneficiaries in the future.
In a discretionary trust, the trustees are the legal owners of any assets held in the trust. They are responsible for running the trust for the benefit of the beneficiaries, with ‘discretion’ about how to use the trust’s income and capital. A discretionary trust may be set up to provide money for a future need that is not yet known - grandchildren, for example.
DISCOUNTED GIFT TRUSTS
A discounted gift trust is a discretionary trust arrangement that is usually set up to look after an investment. It allows an individual to ‘gift’ a lump sum into a trust but lets them keep the income paid out by the investment, usually for the rest of their life. A discounted gift trust is a powerful planning tool for someone who wants to ensure an investment wont be liable to IHT, but where they still need access to the income from the investment itself.
Business property relief (BPR) can be a valuable relief from IHT. It allows you to claim relief on business assets that you own, including qualifying businesses that you hold shares in.
BPR: THE BASICS
BPR was introduced as part of the 1976 Finance Act, and was created to allow small businesses to be passed down through generations without incurring an IHT liability. However, over the years the scope of BPR has been widened, making it an attractive option for individuals looking to invest in companies in order to remove a potential IHT burden.
WHICH COMPANIES QUALIFY FOR BPR?
- Smaller companies that are not listed on the main London Stock Exchange
- Companies that are listed on AIM or Plus stock exchanges
- Businesses considered to be ‘actively trading’, and are therefore not just investment companies
It is worth noting that some businesses, including those that deal in stocks and shares, land or buildings and some specific industries (including resources and mining companies and also not-for-profit organisations) do not qualify for BPR.
INVESTMENTS THAT USE BPR
Some investment companies offer products that invest in companies that qualify for BPR, for example AIM-listed or unquoted companies. This means that the investment itself, as long as it is held for two years, will not be subject to IHT upon the investor’s death. Married couples and civil partners also have the option to transfer the investment between spouses or civil partners. This means that should the investor die during the initial two year period, the investment can be transferred to their surviving spouse or civil partner without resetting the two year clock.
There are a number of rules relating to products that invest in BPR qualifying companies, including that the investment company must invest your money and hold qualifying assets for two years to qualify. They must replace any companies sold from the portfolio within three years, and the assets (and therefore the investment) must be held at time of death for the investor to get IHT relief. Using BPR effectively within investment products is a complicated business, so if you decide this is the right option for you, it’s important to choose a company that’s experienced in investing in this area. The benefits of BPR for investors are outlined on the next page.
WHAT ARE THE BENEFITS OF BPR?
Faster IHT exemption: Unlike gifts and trusts, which generally take seven years before they’re fully exempt from IHT, BPR-qualifying investments are IHT exempt after just two years (provided the investments are held at the time of death).
Greater access and control: Unlike with a gift, the investor retains control over the investment, and can get their money back, if they need to. However, money taken out of the investment may not be shielded from IHT.
Income options: Many BPR solutions allow the investor to take an income from their investment.
Simplicity: BPR investments are relatively simple and straightforward to invest into. Generally there are no complex legal structures, and there may not be a requirement for client underwriting or medical surveys.