Inheritance tax is a tax levied on the ‘estate’ of a deceased person. Value of the deceased’s estate determines the amount you pay. Basically, assets (cash in the bank, investments, property or business, vehicles, life insurance payouts), less any debts determines the value of the estate.
Importantly, there is usually no tax to pay if you meet the following criteria:
- Either your estate is worth less than £325,000,
- Or you leave everything worth more than £325,000 to your spouse, civil partner, charity, or community amateur sports club.
If neither of the above conditions applies. Your estate will have a 40% tax rate on everything above the £325,000 level when you die (or 36 per cent if you leave at least 10 per cent of the net value to a charity in your will).
However, depending on your circumstances. This £325,000 tax-free level might be considerably higher — in some cases, it could be as high as £500,000 or even £1 million.
What happens if I inherit my parents’ home?
In the tax year 2021/22, no inheritance tax is payable on the first £325,000 of an estate, with 40% levied on any sum over that. However, the charges will be lower if you leave your home to your direct descendants, such as children or grandchildren. This is due to the fact that you will then have two tax-free allowances:
• £325,000 — the basic IHT allowance, which remains in effect.
• £175,000 – from 2015, you’ve also been able to benefit from
The ‘residential nil-rate band’ is also known as the ‘main residence band’. If you leave the main house to your children or grandchildren. You will earn this as an additional allowance on top of the normal £325,000 inheritance tax allowance.
This indicates that the inheritance tax depends on who you leave your house to, and the inheritance tax will not be due on the first £500,000 of your estate (£325,000 + £175,000).
• The main residence allowance of £175,000 applies only if your estate is worth less than £2 million.
• For estates worth £2 million or more. The main residence allowance gets reduced by £1 for every £2 over £2 million in the deceased’s property’s worth.
What are the Inheritance tax on gifts?
One of the most common ways to avoid inheritance tax is through gifts.
Gifts are typically exempt from taxation. These include presents between spouses and civil partners and charitable contributions. Other gifts can also be tax-free. However, this depends on the date of manufacturing.
In general, if you make a gift to an individual more than seven years before your death – not to a business or a trust – you won’t have to pay tax on it. If you die within these seven years. The tax payable on gifts can also reduce depending on when its given. We will discuss further on this below.
There are more options to avoid inheritance tax, such as putting your life insurance policy in trust or adding a deed of variation in your will. Trusts can also help you manage your IHT payment and maintain some influence over what happens to your possessions after you die. There are additional options, such as equity release and insurance plans, which we will discuss below.
Who pays the IHT bill?
Inheritance tax is usually paid from your estate on money or possessions handed on when you die. Your estate comprises of everything you possess, less any debts. Such as your mortgage and liabilities such as funeral costs. Your heirs must pay IHT before the end of the sixth month following the death.
Firstly, you require an inheritance tax reference number from HMRC. Moreover, you need to apply for it at least three weeks before making a payment. If the tax is owed on gifts made within the seven years preceding your death. The people who received the gifts must pay the tax in most cases. If they are unable or unwilling to pay. The sum owed gets deducted from the estate.
How to avoid Inheritance tax?
The reasons surrounding inheritance taxation are controversial. Those in favour argue that the wealth perpatuates within the family. So the children of the wealthy remain wealthy. Whereas, Inheritance tax redistributes the income and allows to use it for the benefit of all.
The counter-argument is that tax is paid at the time when money is earned. Thus paying tax on it again is unfair. However, you are liable to pay the tax. As previously indicated, let us look at possible strategies to avoid or reduce the inheritance tax.
By making gifts:
As discussed earlier, spending or giving away your money during your lifetime is one of the simplest ways to avoid paying inheritance tax (IHT). You have the right to spend your money on whatever you choose. Each tax year, you can give away up to £3,000 as a gift, which you can divide among as many persons as you wish. You may also make an infinite number of gifts of up to £250 to others.
If you’re going to a wedding, you can donate up to £1,000 and avoid paying inheritance tax. You can donate up to £2,500 to your grandchildren and £5,000 to your children. Although ensure the wedding gift is given before the wedding. Also, the wedding must take place, or else they will be considered potentially exempt transfers. If you make gifts that exceed the thresholds, they may be taxable if you die within seven years after making them. Otherwise, they will be tax-free as well.
Give money to charity:
Furthermore, if you leave more than 10% of your taxable assets to one of these organisations in your will. The tax rate will reduce from 40% to 36% on the remainder of your estate. The 10% applies only to the amount of your estate that exceeds the lifetime allowance. So, if you left behind £525,000, you would profit from the lower rate if you gave more than £20,000 (10% of the amount over £325,000).
If you leave money to any charity registered in the UK, that money is exempt from inheritance tax. The same is applicable for donations to political parties or local sports teams.
Leave your estate to your spouse:
Your spouse or civil partner will never have to pay tax on any assets you leave them, no matter how large. Making the most of this in your will can save your family thousands of pounds. When you die, your spouse will inherit your unused personal allowance. Which allows them to pass on up to £325,000 more as part of the main IHT allowance.
If they (or you) remarry, unused personal allowances can be joined together and handed on. But only up to the value of one complete personal allowance (i.e., the maximum increase is £325,000). The same is applicable if you are a business owner. Similarly, you can transfer the share of your own without incurring an inheritance tax.
Use property allowances:
IIf you’re leaving your estate to children or grandkids. The new property allowances allow you to transfer more of your home before paying taxes. It is worth £175,000 per individual in the current tax year 2021-22. This boosts the tax-free sum for a married couple by £350,000. Meaning estates worth up to £1,000,000 could be entirely free of IHT this year along with the personal allowance.
Consider equity release:
If your property locks up your entire wealth. You may not be able to use gifts or spend your wealth on yourself during your lifetime. Some people use an equity release technique to get around this. It’s critical to realise that all of this does is lower your assets. Meanwhile, increasing the debts counted against your estate. If you don’t need the money from your property, giving it away sooner is probably better for you.
How equity release programmes work:
With these schemes, you can either borrow money against the value of your property (known as a lifetime mortgage) or sell a portion of your home at a lower market rate while continuing to live there for the rest of your life (a home reversion scheme). You can give the money to your heirs or spend it yourself. If you survive the gift by seven years, there will be no tax to pay.
What happens when you die:
The value of your estate will decrease when you die. Either because of the mortgage debt (if you have a lifetime mortgage) or because just a portion of the value of your home will still belong to your estate (with a home reversion).
What you should be cautious of: It sounds simple enough, but think twice before going down this path. The interest is ‘rolled up’ with lifetime mortgages, and your debt can quickly accumulate. For example, a £50,000 mortgage with a 7% annual interest rate will have nearly doubled to £98,358 within ten years. You may end up paying your lender more than your estate would have paid in taxes – in any case, your heirs will not benefit. The other option involves selling a portion of your home for less than its full value. So consider whether you’re willing to let the bank take half of your house merely to save HMRC from obtaining a piece. Suppose you believe equity release may be suitable for you. In that case, we urge that you always seek the advice of a financial adviser before proceeding.
Purchase life insurance:
If you can’t defeat an IHT bill, you can insure against it. This is one of the simplest ways to cover an unexpected bill. But the cost may be substantial unless you’re reasonably young and healthy. If the policy is incorporated into the trust, the payoff will not be included in your estate.
Unless your policy is written ‘in trust,’ which can often be done at no extra expense when taking out your policy. Most life insurance policies will count as part of the estate.
Your beneficiares will receieve the distributed money rather than your legal estate. As a result, any payment will not count towards your threshold and will not be liable to IHT. This would bypass a lengthy probate process, allowing your beneficiaries to get their funds much sooner. Most people use a whole life insurance policy for this purpose. As long as the policyholder makes the premium payment until death, the policy will remain in force.
If you pay the insurance premiums yourself, HMRC considers them a lifetime gift. They are, however, usually covered by one of the tax-free exemptions, either the annual £3,000 exemption or the ‘gifts out of regular income’ exemption.
Consider a ‘deed of variation’:
A deed of variation allows your heirs to alter your will after death. So that, for example, part of the inheritance is re-directed to someone else. They can draw up a deed of variation within two years of your death, but all affected beneficiaries under the will must agree to the variation. This can be difficult in practice, especially if there are many beneficiaries. As a general rule, it’s better to review your will periodically so that your affairs are tax-efficient. This will simplify the probate process for your executor and reduce the chances of your loved one’s squabbling, which sadly can happen a lot.
How to value the estate for Inheritance Tax
To determine the worth of an estate, you must first:
- identify all assets and calculate their value at the time of death; and
- subtract any debts and liabilities.
Remember to retain records of how you arrived at your conclusion, such as an estate agent’s valuation.
HMRC may seek data for up to 20 years after the payment of Inheritance Tax.
Money in a bank, property and land, jewellery, cars, shares, a payoff from an insurance policy, and jointly owned assets are examples of assets.
Gifts, such as cash or other assets, must also be mentioned if they were handed away during the seven years before the person died.
You must also add any gifts given prior to this time frame if the individual who died continued to benefit from the gift.
They are also known as “gifts with reservations of benefit”. For instance, someone may have given away their home but continued to live in it.
Debts and obligations reduce the deceased’s chargeable estate value. Consider household payments, mortgages, credit card obligations, and, in general, funeral expenses.
However, you cannot deduct after-death expenses such as solicitors’ and probate fees from the estate’s value for IHT purposes. It can be confusing, and it’s better to take expert advice.
Which inheritance tax form should I use?
The tax form which you should use depends upon the gross value of the estate. The Estate’s Gross Value is the total value of all assets before any deductions, such as an outstanding mortgage, vehicle loan, funeral expenses, and other debts. You can take a look at our article, where we discuss which inheritance tax form you should use.