Understanding Inheritance Tax — What You Need to Know
Inheritance tax (IHT) is a significant consideration for those looking to leave wealth to family members or loved ones. While the topic may seem complicated, understanding the basics of how it works, who is liable to pay it, and the ways to reduce it can help you make more informed financial and estate planning decisions. This guide will walk you through the essentials of inheritance tax in the UK, helping you understand how it’s calculated, exemptions, and the strategies to manage it.
What is Inheritance Tax (IHT)?
Inheritance tax is a tax levied on the estate (the property, money, and assets) of a person who has passed away. If the total value of the estate exceeds a certain threshold, inheritance tax may be charged on the value above this threshold. For individuals, the standard IHT threshold is £325,000, meaning that if the estate’s value exceeds this amount, inheritance tax may be due. However, the rules surrounding IHT can be more complex when it comes to different types of property, allowances, and reliefs.
The current inheritance tax rate is 40%, but it only applies to the value of the estate that exceeds the £325,000 threshold. There are several exemptions and allowances that can reduce or eliminate the IHT liability, including those related to gifts, charitable donations, and passing assets to a spouse or civil partner.
How is Inheritance Tax Calculated?
Valuing the Estate: The first step is determining the total value of the deceased person’s estate. This includes property, savings, investments, and any other valuable items, such as cars, jewelry, and other possessions. The valuation should include both the market value of assets and any debts owed by the deceased.
Exemptions and Allowances: Some assets are exempt from inheritance tax, such as those passed to a spouse or civil partner, or certain types of gifts made during the person’s lifetime. The deceased may also be entitled to a residence nil-rate band (RNRB) if the family home is passed on to direct descendants. There is also the annual gift allowance, which allows people to give gifts of up to £3,000 per year without incurring IHT.
Calculating Taxable Estate: Once exemptions have been applied, any remaining value of the estate over the threshold will be subject to IHT. This is charged at a standard rate of 40%. However, if at least 10% of the estate is left to charity, the inheritance tax rate can be reduced to 36%.
Common Exemptions and Reliefs
Inheritance tax is a tax on the value of assets transferred, but not all assets are treated the same. Here are some of the most common exemptions and reliefs:
Spouse or Civil Partner Exemption: Assets passed to a spouse or civil partner are usually exempt from inheritance tax. This includes not only estates but also lifetime gifts. Furthermore, if a spouse or civil partner leaves their estate to the other, the unused part of the £325,000 allowance can be transferred.
Charitable Donations: Inheritance tax is not charged on donations made to charities. In fact, leaving at least 10% of an estate to charity can reduce the inheritance tax rate from 40% to 36% (if the estate is large enough).
Annual Gift Allowance: You can gift up to £3,000 in a single tax year without this being subject to inheritance tax. This gift allowance can be carried forward for one year if unused.
Business Property Relief (BPR) and Agricultural Property Relief (APR): These reliefs can apply to business assets and agricultural land, potentially reducing the taxable value of those properties. Business owners, for instance, may find significant relief through BPR if they pass on their business to family members or employees.
Gifts Between Individuals: Gifts made during a person’s lifetime can also be exempt from IHT if they are below certain thresholds. A gift made seven or more years before death is typically exempt from IHT (although there are exceptions, such as if the giver continues to benefit from the gift).
10 Ways to Reduce Inheritance Tax
Inheritance Tax can be a significant cost for your beneficiaries, but there are multiple strategies that can help reduce the amount of tax your estate may be liable for. Here are ten practical ways to minimize inheritance tax and preserve more wealth for your heirs:
1. Utilise the Nil-Rate Band (NRB)
The nil-rate band (NRB) allows individuals to leave up to £325,000 of their estate free from inheritance tax. If you are married or in a civil partnership, any unused NRB from your spouse or partner can be transferred, effectively doubling the threshold to £650,000. If your estate value is under this amount, no IHT is due.
2. Residence Nil-Rate Band (RNRB)
If you are passing on your home to direct descendants (children or grandchildren), you may qualify for the residence nil-rate band (RNRB). This adds an additional £175,000 tax-free allowance in 2021/22, increasing your potential tax-free threshold to £500,000 (£650,000 for married couples).
3. Gifting During Your Lifetime
One of the simplest ways to reduce IHT is by gifting assets while you’re still alive. Lifetime gifts are potentially exempt from IHT if the giver survives for seven years after making the gift. Gifts made to spouses or civil partners are entirely exempt from IHT, and there’s also a small gifts exemption of £250 per person per year.
4. Use the Annual Gift Allowance
You can gift up to £3,000 per year without incurring any IHT, and this allowance can be carried forward for one year if unused. This allows you to gradually reduce the size of your estate and minimize tax liabilities.
5. Give to Charity
Gifts to charitable organisations are exempt from inheritance tax. Additionally, if you leave at least 10% of your estate to charity, the rate of inheritance tax on the rest of your estate can be reduced from 40% to 36%. This is a powerful tool for reducing tax liability while supporting causes you care about.
6. Establish Trusts
Placing assets into trusts can be an effective way to reduce IHT, particularly if you do so early in life. Trusts can remove assets from your estate for IHT purposes while ensuring the beneficiaries receive the assets under certain conditions. The seven-year rule applies, meaning that gifts into trust are generally exempt from IHT if you survive for seven years after making the gift.
7. Make Use of Business Property Relief (BPR)
If you own a business, you may be eligible for Business Property Relief (BPR), which can reduce or eliminate IHT on business assets. This relief is available for a variety of business interests, including shares in a family business, and can be a valuable tool for entrepreneurs looking to pass on their businesses to the next generation.
8. Agricultural Property Relief (APR)
If you own agricultural property, Agricultural Property Relief (APR) can provide significant relief from IHT. The relief can apply to land, buildings, and even farming equipment, reducing the taxable value of your estate if these assets are passed to a direct descendant.
9. Use Life Insurance
A life insurance policy written into trust can be an excellent way to cover any potential inheritance tax liability. The policy proceeds will go directly to your beneficiaries, bypassing the estate and helping them pay any IHT that may be due. This can be particularly useful for those with large estates.
10. Create a Family Investment Company
Setting up a family investment company (FIC) is a more advanced strategy. It allows family members to hold shares in the company, which can be structured to transfer wealth while reducing IHT. The company can own various assets, such as property or investments, and the value of the estate can be reduced over time by transferring shares to younger generations.
Conclusion: Plan Ahead for Inheritance Tax
Inheritance tax can be a significant financial burden for those leaving behind an estate. However, with proper planning, it is possible to minimise the tax liability and ensure that more of your assets are passed on to your loved ones or chosen causes.
Whether through gifting, trusts, or careful planning, understanding inheritance tax and using the available exemptions and reliefs can help reduce the financial impact of IHT. It’s also essential to review your estate regularly and ensure that your plan aligns with your goals.
To get the most out of your inheritance tax planning, it’s advisable to consult with an estate planning professional or financial advisor. They can guide you through the options and help you create a strategy that maximises your estate’s potential while minimising taxes.
