What is Inheritance Tax?

Inheritance Tax (IHT) is an important aspect of estate planning in the United Kingdom. It is a tax that may be levied on the estate of an individual who has passed away, which includes all their property, possessions, and financial assets. Proper knowledge of IHT is crucial for people planning their estate to minimise the tax impact on what beneficiaries ultimately receive.

Understanding how inheritance tax works is essential, particularly in relation to gifts and the 7-year rule. Gifts given more than 7 years before death are generally exempt from IHT, while those given within 7 years may be subject to tax depending on their value and the inheritance tax threshold.

In this article, we will explore the details of Inheritance Tax in the UK, how it is calculated, who is liable, and strategies to potentially reduce it. We will also answer frequently asked questions to help you understand the essentials of IHT in the UK.

What is Inheritance Tax?

Inheritance Tax is a levy on the estate of a person who has died. An estate includes all property, money, and other assets owned by the deceased, often referred to as the whole estate. It also encompasses gifts made within the last seven years before their death. Understanding what counts towards the value of an estate is critical to determining whether IHT is payable.

What Does the Estate Include?

An estate is composed of:

• Real Estate: Houses, apartments, land, and other properties owned by the deceased.

• Financial Assets: Bank accounts, stocks, investments, and bonds.

• Personal Property: Vehicles, antiques, jewellery, collectibles, and other valuable personal items.

• Gifts Made Before Death: Any monetary or asset-based gifts given in the last seven years are subject to IHT and can be included within the value of the estate. If the person who made the gift continues to live in the property rent free, it is considered a 'gift with reservation' and can affect the inheritance tax calculations.

The responsibility to pay IHT falls on the executor or administrator of the estate, who must settle any tax liabilities before distributing assets to the beneficiaries.

How is Inheritance Tax Calculated?

Understanding the Thresholds

In the UK, Inheritance Tax is only charged on estates whose value exceeds a certain threshold known as the nil-rate band.

• As of the current tax year, the nil-rate band is £325,000. Estates valued below this amount are exempt from IHT.

• Any value exceeding £325,000 is taxed at a rate of 40%, meaning beneficiaries will need to pay tax on the amount over the threshold.

For example, if an estate is valued at £425,000, the taxable portion would be £100,000, resulting in an Inheritance Tax liability of £40,000.

Residence Nil-Rate Band (RNRB)

There is also an additional allowance called the Residence Nil-Rate Band (RNRB). This applies to individuals leaving their main residence to a direct descendant, such as a child or grandchild.

• The RNRB currently stands at £175,000, which means the potential tax-free threshold can rise to £500,000 if the estate includes a primary residence being left to descendants.

For married couples or civil partners, the unused allowance from the first partner’s estate can be transferred to the surviving partner’s estate, providing a combined threshold of up to £1 million.

Valuing the Estate

To determine whether Inheritance Tax is payable, it is essential to value the estate correctly. This process involves:

1. Property Valuation: Estimating the market value of any properties owned.


2. Financial Assets: Valuing bank accounts, shares, and other investments.


3. Personal Possessions: Valuing all significant personal belongings like jewellery, art, and vehicles.


4. Debts and Liabilities: Deducting any outstanding debts (e.g., mortgages, credit cards) from the estate to arrive at the net value.

Gifts and Exemptions in Inheritance Tax

Annual Gift Exemption

Each individual can give away up to £3,000 per year as gifts without the gifts being subject to Inheritance Tax. If the exemption is unused in one year, it can be carried over to the next year, allowing for up to £6,000 in gifts.

Small Gifts Exemption

Gifts of up to £250 per person can be given each year to as many individuals as desired without being counted towards the estate for IHT purposes.

Gifts to Spouses or Civil Partners

Gifts made to a spouse or civil partner are generally exempt from Inheritance Tax, provided that both individuals are permanent residents of the UK.

Gifts on Weddings and Civil Partnerships

Gifts given on the occasion of a wedding or civil partnership are exempt up to:

• £5,000 if given by a parent.

• £2,500 if given by a grandparent.

• £1,000 if given by anyone else.

Charitable Gifts

Gifts left to registered charities are exempt from IHT. Furthermore, if an individual leaves at least 10% of their estate to charity, the tax rate on the remaining estate can be reduced from 40% to 36%.

The Seven-Year Rule and Taper Relief

Gifts made within seven years before death may still be liable for Inheritance Tax under the seven-year rule. The tax payable on gifts gradually reduces based on how many years before death the gift was made. This reduction is known as taper relief:

• 3 to 4 years before death: 32% rate.

• 4 to 5 years before death: 24% rate.

• 5 to 6 years before death: 16% rate.

• 6 to 7 years before death: 8% rate.

Strategies to Reduce Inheritance Tax

Inheritance Tax can significantly impact the value of an estate passed on to beneficiaries. Below are some common strategies that individuals in the UK use to minimise IHT:

1. Setting Up Trusts

Trusts are effective tools for estate planning and reducing IHT. Assets placed in a trust are no longer counted as part of the estate, making them exempt from IHT, provided certain conditions are met.

Types of Trusts

• Bare Trusts: Assets held in the beneficiary’s name, which fall outside the estate.

• Discretionary Trusts: The trustee has discretion over how to distribute the trust’s assets to beneficiaries, offering flexibility.

• Life Interest Trusts: Individuals can benefit from income generated by the trust’s assets while retaining the principal value for other beneficiaries.

Setting up a trust can be complex, so it is recommended to seek professional advice.

2. Using Exemptions

Making the most of annual gift exemptions and small gift exemptions can help reduce the estate’s value over time. Regular gifting of assets within allowed limits is a simple and effective way to lower IHT liabilities.

3. Leaving Assets to a Spouse or Charity

Leaving assets to a spouse or civil partner is exempt from Inheritance Tax. Similarly, leaving a portion of the estate to charity can reduce or eliminate IHT liabilities, especially if it reduces the estate below the taxable threshold or qualifies for the reduced rate of 36%.

Paying Inheritance Tax

When and How to Pay

Paying Inheritance Tax (IHT) is a crucial responsibility that falls on the executor of the estate. The executor is tasked with managing the deceased person’s assets and ensuring that all tax liabilities are settled before distributing the remaining estate to the beneficiaries. To avoid penalties and interest, it is essential that the executor pays IHT within six months of the end of the month in which the person passed away.

There are several methods available for paying IHT, making it convenient for executors to fulfill this obligation:

• Online Payment: Executors can pay IHT online through the HMRC website. This method requires the deceased person’s Unique Taxpayer Reference (UTR) number and the estate’s IHT reference number. Online payment is often the quickest and most efficient way to settle the tax.

• Bank Transfer: Another option is to pay IHT via bank transfer. Executors will need the HMRC bank account details to complete this transaction. This method is secure and allows for direct transfer of funds.

• Cheque: Executors can also pay IHT by sending a cheque made payable to “HM Revenue & Customs Only”. This traditional method may take longer to process, so it’s important to account for mailing and processing time to ensure timely payment.

By understanding these payment methods, executors can choose the most suitable option to ensure that the IHT is paid promptly, thereby avoiding any complications.

Penalties for Late Payment

Timely payment of Inheritance Tax is critical, as failing to meet the deadline can result in significant penalties and interest charges. If the executor does not pay IHT within the stipulated six-month period, they may face the following penalties:

• 5% of the Unpaid Tax: If the payment is made within 30 days after the due date.

• 10% of the Unpaid Tax: If the payment is made between 30 days and 6 months after the due date.

• 15% of the Unpaid Tax: If the payment is made more than 6 months after the due date.

In addition to these penalties, interest will also accrue on the unpaid tax. The current interest rate is 3.25% per annum, which can add up quickly if the tax remains unpaid for an extended period.

It is important for executors to be aware that they can appeal against any penalties or interest charged by HMRC if they believe the payment was made on time or if there were exceptional circumstances that prevented timely payment. This appeal process provides a safeguard for executors who may encounter unforeseen difficulties in managing the estate.

By understanding the importance of timely payment and the potential consequences of delays, executors can better navigate the responsibilities of managing an estate and ensure compliance with IHT regulations.

The Role of Executors in Inheritance Tax

The executor of the estate plays an important role in ensuring that all taxes are calculated and paid correctly. Executors are responsible for:

1. Valuing the Estate: Determining the total value of the estate, including assets and liabilities.


2. Applying for Probate: Probate is the legal process that gives the executor the authority to handle the estate.


3. Paying Inheritance Tax: Executors must ensure to pay inheritance tax (IHT) before any assets are distributed to beneficiaries.


4. Distributing the Estate: After settling all debts and taxes, the executor distributes the remaining assets to the heirs according to the will.

Executors can be personally liable if they fail to assess or pay the IHT properly, which makes it critical to have a good understanding of IHT rules.

Frequently Asked Questions

1. What is the current inheritance tax threshold?

The current nil-rate band is £325,000, which means that estates below this value are exempt from IHT. There is also an additional Residence Nil-Rate Band of £175,000 for a main residence left to descendants.

2. How is inheritance tax calculated?

IHT is calculated based on the total value of the estate after deducting debts, liabilities, and exemptions. A 40% rate is applied to the value exceeding the nil-rate band.

3. Are gifts during a lifetime subject to inheritance tax?

Gifts made within seven years of death may be subject to IHT, although there are exemptions such as the annual gift exemption of £3,000 per year.

4. How can I reduce my inheritance tax liability?

There are several strategies to reduce IHT, such as setting up trusts, utilising exemptions for gifts, and leaving assets to charity or a spouse.

5. Who pays inheritance tax?

The estate is responsible for paying Inheritance Tax, and it is managed by the executor before the distribution of assets to beneficiaries.

6. What happens if inheritance tax is not paid?

If IHT is not paid, the estate's assets may be frozen until the tax is settled, and the executor may be held personally liable for any unpaid tax.

Conclusion

Inheritance Tax is an important aspect of estate planning that can significantly affect the value passed on to beneficiaries. Understanding the thresholds, exemptions, and possible strategies to reduce the impact of IHT can help ensure that more of the estate goes to your loved ones rather than being lost to taxation.