Beginners Guide to Inheritance Tax

This is intended to provide information only and reflects our understanding of legislation at the time of writing. Before you make any decision, we always suggest you take professional financial advice.

Inheritance tax (IHT) has traditionally been seen as a tax only for the very wealthy. However, with a threshold of £325,000(1) (£650,000 for married couples and civil partners) and the price of houses in this country at close to all-time highs, more and more people are finding themselves caught in the trap.

This could lead to many people having to sell long-held family heirlooms or investment assets to meet tax bills which a little bit of planning could help avoid.

This guide is designed to outline what IHT is, who needs to be concerned, how it works and also introduces some of the allowances you can use to help mitigate its effects on your estate. If you would like to discuss any of the points raised, please do not hesitate to contact us.

(1)Tax Year 2014/2015

What is Inheritance Tax?

Inheritance Tax is paid when someone passes over ownership of their assets on death. Each individual is entitled to a “nil rate band” (NRB), under which no IHT is payable and traditionally very few estates have exceeded this nil rate band.

However, the house price boom of recent years has pushed millions more people into the IHT net. The Treasury's 2005/06 receipts from IHT payments were up 60% on 1999/2000(2).

Although inheritance tax is technically payable on the transfer of assets after death, there are a number of measures in place to ensure that people don't simply hand everything over to their loved ones on their death beds to avoid it. Any gifts given within the seven years prior to death need to be included in the value of an estate for inheritance tax assessment. Equally, you shouldn't forget ISAs, death-in-service benefit, foreign homes or less obvious assets such as paintings or cars, when calculating the value of your estate.

Your tax bill for all assets over the NRB will be 40% so it is possible to build up a large bill quickly. Also, inheritance tax becomes payable relatively quickly. It is due six months after the end of the month of death.

This doesn't give the administrators much time to, say, sell a house, or liquidate other assets if that is necessary. With that in mind, if you unexpectedly find that your estate now exceeds the Inland Revenue limits, what can you do?

Basic Example

Assuming no previous gifts have been made in the preceding 7 years, the total value of the estate is therefore £635,000. If we take away the NRB of £325,000 the remainder of £310,000 is taxed at 40% meaning a tax bill of £124,000 is potentially payable. However with the new Residential Nil rate band now potentially available, a further £125,000 is also free of IHT meaning the tax bill could reduce to £74,000 (tax year 2018/19)

(2)Source: HM Treasury Inheritance tax analysis table 12.1; tax year 2005/06 relative to tax year 1999/2000

What are the Exemptions?

Although the Government closed many of the Loopholes on IHT in the 2006 Budget, a number of exemptions and allowances remain. Where possible, you should aim to maximise use of these exemptions and allowances in order to pass as much of your hard earned cash on to your heirs as possible.

In addition to the £325,000 nil rate band available on each estate, transfers between husband and wife or between civil partners are tax free. Since 9 October 2007, such legally recognised partners can also pass over any unused portion of their own nil rate band so that, in effect, the surviving spouse has up to £650,000(3). However, this does not apply to cohabiters or 'common-law' spouses.

The majority of other exemptions and allowances come about through distributing some of your wealth prior to death. Assets transferred prior to death are 'potentially exempt transfers' (PETs) for IHT purposes. They are potentially exempt, because, from the day you give them away, the tax due on death is subject to a tapering over 7 years, starting at 100% of liability for the first three years then falling proportionally from 80% over the next four. If you survive the full seven years, your liability on that asset is zero.

However, this taper relief does only apply to amounts in excess of the nil rate band. As there is no tax due on the first £325,000, then no taper relief can apply. Therefore, if you give away anything up to £325,000 and die within those seven years, the full amount of the original gift will be added back in to your estate and tax will be calculated on the total as if you never gave that amount away.

Having said that, if you do survive seven years, then that amount is considered as having left your estate and you therefore get the chance to benefit from the nil rate band allowance a second time.

However, there is an important restriction on PETs called a 'gift with reservation of benefit'. The principle is that if you continue to enjoy the benefit of an asset the transfer is entirely ineffective for inheritance tax purposes. This is in place to stop people simply transferring their homes to their children and continuing to live in them. In order for this to be potentially exempt, a full market rent would have to be paid to the children after transfer.

Gifts of £3,000 or less are allowed annually without being liable for IHT - and if unused, this allowance can be carried forward for one year. There is also a gift exemption applying to 'regular gifts out of income'. These gifts can be as much as you like, but they must form part of a 'pattern of giving' and the Inland Revenue must be satisfied that after the gift has been made, you are left with sufficient income to maintain your standard of living.

You are also allowed gifts on consideration of marriage or civil partnership. The amounts vary according to your relationship to the bride and groom - at the moment, £5,000 is allowed from the parents, £2,500 from the grandparents and £1,000 by anyone else. Gifts to charities also fall outside inheritance tax.

Planning

To make sure you make full yet practical use of your allowances and exemptions, there are some basic steps you can take. Planning ahead is very important. Inheritance Tax is no longer the “voluntary” tax it was once considered. However, careful planning to ensure you take advantage of all the allowances and reliefs available could save you a lot of money relatively easily. It’s never too early to start.

In the Summer Budget 2016, the rules on Inheritance tax changed, providing for an addtional "family home" allowance where an individual's main residence forms part of their estate. In 2018/19 while the Inheritance Tax threshold remains unchanged on 2017/18 at £325,000, the family home allowance has increased from £100,000 to £125,000.  Individuals can now pass on assets - which include the family home - to their children or grandchildren worth up to £450,000, with no Inheritance tax liability.