Inheritance Tax (IHT) is tax on the estate of someone who has died and includes all of their property, money and possessions. Usually only a small percentage (4.5% on average) of estates are actually large enough to incur IHT, however, it’s something you should factor into your plans when creating your will. In this guide, we’ll be taking a further look at what IHT is, how to calculate the amount you’ll need to pay, when you’ll need to pay it and some tips on how to reduce the tax.
Normally you won’t need to pay inheritance tax if:
- Your estate has a value below the Nil Rate Band (NRB) of £325,000
- You leave everything above the threshold to your spouse or civil partner or
- You leave everything above the threshold to an exempt beneficiary e.g. a charity
If the value of your estate is higher than the RNB, then any amount over the threshold may be liable to tax at the rate of 40%. This means that if your estate is worth £475,000 and your IHT threshold is £325,000, the tax charge will be on £150,000. 40% of this is £60,000 so you would be charged £60,000 in tax.
The NRB is currently fixed at £325,000 however, your NRB may be increased if you are a widow or a surviving civil partner. If you are married or in a civil partnership and your estate is below your threshold, you can transfer any unused threshold to your partner’s when you die, meaning their threshold can be as high as £1 million. This extra transferable amount is known as Transferable Nil Band (TNRB).
If you pass your home or a share of it to your children/grandchildren (including step-children, adopted children and foster children but excluding nieces nephews and siblings), you may be eligible for the Residence Nil Rate Band (RNRB) or ‘home allowance’ which has been recently introduced.
This is on top of the NRB and TNRB and gives you an additional allowance which can be used to reduce IHT liability against your home. Any unused RBRB can also be left to your spouse or civil partner, doubling their amount of RNRB available. Similarly, you may be able to use any unused RNRB from their estate should you become widowed or a surviving civil partner.
In the 2020-2021 tax year, the Resident Nil Rate Band is £175,000, giving you an allowance of £500,000 when combined with the Nil Rate Band. If the value of your estate exceeds £2 million, there is tapered withdrawal of the home allowance at a rate of £1 for every £2 over the threshold.
How to Calculate the Value of an Estate
In order to value an estate, you will need to:
- Make a list of all the assets and work out their value at the date of death
- Deduct any debts owed and any liabilities
- Report the value to HMRC
Assets are items such as property, land, money, shares, an insurance policy pay-out, cars, jewellery and any jointly owned assets. These also include cash or high value gifts given by the deceased up to seven years prior to their death.
If the deceased gave away more than £325,000 in the form of a gift or cash in the seven years prior to their death, the recipients will be charged.
Exempted Gifts
Each tax year (6 April – 5 April) you can give away gifts with a value of up to £3,000 without having to add them to the value of the estate. This is called your ‘annual exemption’. If you have any unused annual exemption you are able to carry it forward to the next year but this may only be for one year.
Each tax year, you may also give away:
- Wedding/civil ceremony gifts worth up to £1,000 per person (or £2,500 for a grandchild/great-grandchild or £5,000 for a child).
- Ordinary gifts out of your income e.g. birthday or Christmas gifts, though you must be able to maintain your standard or living after giving the gift.
- Payments to help someone else’s living costs e.g. an elderly relative or a child under 18.
- Gifts to charities or political parties.
You are also able to give as many gifts as you want with a value of up to £250 per person during the tax year so long as you haven’t used another exemption on the same individual.
The 7 Year Rule
When paying inheritance tax, it’s charged at 40% on gifts given within 3 year prior to your death. Any gifts given between 3 and 7 years prior to your death are taxed on a scale known as ‘taper relief’.
| Years between gift given and death | Tax paid |
| <3 | 40% |
| 3-4 | 32% |
| 4-5 | 24% |
| 5-6 | 16% |
| 6-7 | 8% |
| ≥7 | 0% |
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For example:
Bill died on 1 June 2020. He wasn’t married or in a civil partnership when he died.
Bill gave 3 gifts in the 7 years prior to his death
£300,000 to his sister 6.25 years before his death
£50,000 to his nephew 4.75 years before his death
£150,000 to his friend 3.5 years before his death
Bill isn’t eligible for any other gift exemptions or reliefs.
As there is a £325,000 inheritance tax threshold, anything given below this amount is tax free.
£300,000 is used by the gift Bill gave to his sister. There is no tax to be paid on this gift.
The remaining £25,000 is used by the £50,000 he gave to his nephew. There is no tax to pay on the first £25,000 of the gift as this is covered by the threshold, however, there is tax at a rate of 24% to be paid on the remaining £25,000 of the gift to Bill’s nephew.
The £150,000 he gave to his friend is taxed at a rate of 32%.
Bill’s remaining estate was valued at £500,000 and charged at the usual 40% inheritance tax rate as Bill used up the tax-free threshold on gifts he gave before his death.
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Gifts with Reservations of Benefit
Any gifts with reservations of benefit must also be valued. These are gifts given before the seven year period but ones that the deceased continued to benefit from. Gifts are considered to be ‘subject to a reservation’ if they meet either of the following criteria:
- The gift recipient didn’t take possession of the property or benefit from the property prior to the deceased’s death, or;
- The property was not enjoyed by the recipient to either the entire exclusion of the deceased or virtually the entire exclusion of deceased at any time prior to their death (e.g. if the deceased continued to live in the property after gifting it)
Deducting Debts and Liabilities
Debts and liabilities can help to reduce the value of the deceased’s chargeable estate. Any debts owed such as household bills, mortgages and credit debts can be deducted, though it’s important to note that any costs incurred after their death cannot be deduced due to inheritance tax purposes.
Reporting the Value to HMRC
In order to work out how much to report to HMRC, you should:
- Take the gross value of the estate (the value of all its assets)
- Deduct any debts or liabilities
- Deduct any reliefs
- Deduct the value of any assets left to spouses, civil partners, charities or any other recipients that are exempt
This leaves you with the value of the estate that is taxable.
You should then take the available Inheritance Tax threshold e.g. £325,000 and:
- Include any unused basic threshold that has been transferred from a late spouse or civil partner’s estate (RNRB)
- Deduct the value of gifts made within 7 years prior to the deceased’s death where applicable
- Add any Inheritance Tax that must be paid on gifts valued above the basic threshold
- Compare the value of the estate at the end of step 4 with the available threshold at the end of step 7.
- If the value of the estate at the end of step 4 is less than the available threshold at the end of step 7, there is no Inheritance Tax to pay. If it is more, Inheritance Tax must be paid on the excess.
- Deduct the value of gifts made within 7 years prior to the deceased’s death where applicable
- Add any Inheritance Tax that must be paid on gifts valued above the basic threshold
- Compare the value of the estate at the end of step 4 with the available threshold at the end of step 7.
- If the value of the estate at the end of step 4 is less than the available threshold at the end of step 7, there is no Inheritance Tax to pay. If it is more, Inheritance Tax must be paid on the excess.
Once you have compiled all the information and figures, you need to report the estate’s value in detail to HMRC. This can be done online or via a paper form.
Ensure you keep a record of your calculations, detailing how you worked out the value of each asset by including information such as an estate agent’s valuation. HMRC may ask to see these records up to twenty years after the Inheritance Tax has been paid, so it’s important to keep them in a safe place where you can easily find them should they ever be requested.
Who Pays the Inheritance Tax?
Normally, the executor of the will will be the one to arrange the payment of the Inheritance Tax, however, in cases where there isn’t a will, the administrator of the estate will take on this role. Inheritance Tax can be paid with funds from the estate or via funds raised from the sale of assets.
Most Inheritance Tax is paid with the Direct Payment Scheme (DPS) which means if there is any money left in the deceased’s bank or building society account, the person handling the estate can request for all or some of the Inheritance Tax due to be paid directly from the account through DPS.
Other times, the deceased will leave money aside to pay the Inheritance Tax and this is usually arranged through a whole-of-life insurance policy.
When Must Inheritance Tax be Paid By?
Inheritance Tax must be paid by the end of the sixth month period following the individual’s death. If it is not paid within this period, HMRC will charge interest.
The executors of the will can choose to pay tax on certain assets e.g. property, by instalment over 10 years, however, the outstanding amount of tax will be charged interest. If the asset is sold prior to the payment of the Inheritance Tax, the executors must make sure that all instalments and any interest are paid by that point.
If an estate is likely to incur Inheritance Tax, a wise move is to get your will executor to pay off some of the tax within the first six months following the death, even if the estate hasn’t been fully valued yet. This is known as ‘payment on account’ and helps to reduce the interest that could be incurred should the assets take a long time to sell and debts to be paid.
Should the executor make a payment from their own account, it can be later claimed back from the estate. If you have been appointed as the executor of the will or administrator of the estate, you’ll need to send an account of the estate to HMRC within 12 months of the death or you’ll risk facing a penalty.
How Can I Reduce My Inheritance Tax?
Some ways in which you can reduce the amount of inheritance tax due are:
- Frequently give gifts up to a value of £3,000 a year
- Leave your estate to a spouse/civil partner
- Pay into a pension as opposed to a savings account
- Put your assets into a trust for your heirs
- Leave a legacy to a charity
Can I Use Life Insurance to Pay Inheritance Tax?
You can take out a life insurance policy to help pay some or all of your Inheritance Tax bill, making the process easier for those handling your estate following your death. It can also help to protect your home and assets from being sold in order to pay the bill, offering you peace of mind when it comes to continuing to support your family even after you have died by not landing them with a large tax bill to pay.
The majority of life insurance policies are counted as part of the estate unless your policy is specifically written ‘in trust’. This can be done at no extra cost when you take out your policy.
Looking to Plan Your Estate?
Few of us want to start thinking about dying, but equally, few of us could live with the thought that we have not made adequate provision for family and friends who survive us. The sooner you make the arrangements, the greater your chance of taking full advantage of the tax opportunities available, thereby maximising the amount that goes to your beneficiaries.
At Ryans, we provide a discreet estate planning service that includes:
- Help with drawing up and reviewing your will
- Making full use of exemptions and lower tax rates on lifetime transfers
- Optimising lifetime transfers between spouses
- Transferring agricultural or business property
- Transferring assets into trust
- Arranging adequate life assurance to cover potential inheritance tax liabilities
As morbid of a conversation it may be, it’s one that should happen before it’s too late, so let’s talk.