Beginners’ guide to Inheritance Tax Planning
This guide …
Benjamin Franklin was right when he said the only two certainties in life were ‘death and taxes’. And when it comes to inheritance tax, the two things collide.
But why should the taxman take some of your assets when you die – especially since you have probably already paid income tax on the money earned to buy them and capital gains tax on any profits.
However, there are ways to reduce the amount of inheritance tax you have to pay. This guide explains how the tax is levied and how you might keep your payment to a minimum.
The information in this guide is based on current tax rules and legislation, which could change in the future.
Tax treatment depends on your individual circumstances and may be subject to change in the future.
What is Inheritance tax?
Inheritance tax, or IHT as it is commonly known, is payable on everything you have of value when you die, including:
- Your home
- Savings and investments
- Works of art
- Any other properties or land – even if they are overseas.
It’s usually payable on death. But there are certain circumstances, if you put assets into certain types of trusts, for example, when IHT becomes payable earlier.
When you die your assets become known as your estate. Any part of your estate that is left to your spouse or civil partner will be exempt from IHT. The exception is if your spouse or civil partner is domiciled outside the UK. Then the maximum you can give them before IHT may need to be paid is £325,000. Unmarried partners, no matter how long-standing, have no automatic rights under the IHT rules.
Where your estate is left to someone other than a spouse or civil partner (i.e. to a non-exempt beneficiary), IHT will be payable on the amount that exceeds the nil rate threshold. The current threshold is £325,000. The threshold usually rises each year but has been frozen at £325,000 for tax years up to and including 2020/21.
Every individual is entitled to a Nil Rate Band (that is, every individual is entitled to leave an amount of their estate up to the value of the nil rate threshold to a non-exempt beneficiary without incurring IHT). If you are a widow or widower and your deceased spouse did not use the whole of his or her Nil Rate Band, the Nil Rate Band applicable at your death can be increased by the percentage of nil rate band unused on the death of your deceased spouse, provided your executors make the necessary elections within 2 years of your death.
To calculate the total amount of IHT payable on your death, gifts made during your lifetime that are not exempt transfers must also be taken into account. Where the total amount of non-exempt gifts made within seven years of death plus the value of the element of your estate left to non-exempt beneficiaries exceeds the nil rate threshold, IHT is payable at 40% on the amount exceeding the threshold. This reduces to 36% if the estate qualifies for a reduced rate as a result of a charity bequest. In some circumstances, IHT can also become payable on the lifetime gifts themselves – although gifts made between three and seven years before death could qualify for taper relief, which reduces the amount of IHT payable.
From 6 April 2017, an IHT ‘residence nil rate band’ is available in addition to the standard nil rate band. It’s worth up to £100,000 for 2017/18, £125,000 for 2018/19, £150,000 for 2018/20 and £175,000 for 2020/21. It starts to be tapered away if your IHT estate is worth more than £2 million on death. Unlike the standard nil rate band, it’s only available for transfers on death. It’s normally available if you leave a residential property that you’ve occupied as your home outright to direct descendants. It might also apply if you’ve sold your home or downsized from 8 July 2015 onwards. If spouses or civil partners don’t use the residence nil rate band on first death – even if this was before 6 April 2017 – there are transferability options on second death. As a number of conditions apply, it’s best to review your will with a specialist legal adviser if you’re hoping to rely on the residence nil rate band.
Your executors or legal personal representatives typically have six months from the end of the month of death to pay any IHT due. The estate can’t pay out to the beneficiaries until this is done. The exception is any property, land or certain types of shares, where the IHT can be paid in instalments. Then your beneficiaries have up to 10 years to pay the tax owing, plus interest. At the time of writing interest is charged at 2.75% on instalments or late payments. If you pay by instalments you must pay a tenth of the amount of tax owed each year for 10 years.
Taper relief applies where tax, or additional tax, becomes payable on your death in respect of gifts made during your lifetime. The relief works on a sliding scale. The relief is given against the amount of tax you’d have to pay rather than the value of the gift itself. The value of the gift is set when it’s given, not at the time of death.
|Years before death in which transfer made||Taper relief|
- You’d made a non-exempt gift of £350,000 on 1 February 2009 and died on 20 June 2012.
- The IHT nil-rate threshold at the date of death was £325,000.
- The gift exceeds the threshold by £25,000
- Full rate of tax on the gift: 40% x £25,000 = £10,000
- The gift was made within 3 to 4 years of death, so taper relief at 20% is due.
- Taper relief: £10,000 x 20% = £2,000
- Revised tax charge: £10,000 - £2,000 = £8,000.
Writing a will
One of the most important things you can do to help reduce the amount of IHT you’ll have to pay, is write a will. If you die without a will, your estate is divided out according to a pre-set formula and you have no say over who gets what and how much tax is payable.
Get professional advice
You should consider getting professional advice, as an expert will be able to tell you the best and most tax-efficient way to write your will.
Wills for couples
Many couples write mirror wills, which mean the same things take effect regardless of which partner or spouse dies first. You can’t have a joint will. Married couples and civil partners may be able to make tax savings where wills are written to incorporate discretionary trusts of the nil rate band. You should speak to your solicitor for more details.
Keeping your will up-to-date
You need to keep your will up-to-date. Getting married, divorced or having children are all key times to review your will. If the changes are minor, you could add what’s called a codicil to the original will. This is a document which can have the effect of making small amendments to your original will. You should consult a solicitor before doing this. If they’re major, consider writing a new one.
Put your will in a safe place and make sure the executors know where it is.
You’ll need to ask yourself some questions before you write your will:
- Who do I want to benefit – my spouse or partner, children or other friends and relations? They become known as the beneficiaries.
- How much do I want to give them? You can either give a named legacy – such as a family heirloom or treasured item – or a monetary gift.
- How do I own my house? If you own it as ‘tenants in common’ with your spouse or partner, then you each own a percentage that can be left to another person on death. Owning a property as ‘joint tenants’ means that you both own 100% and it solely belongs to the other on your death. Different property ownership rules apply in Scotland.
- Who do I want to look after any of my children under the age of 18 when I die? They will become their legal guardians.
- Who do I want to administer my will when I die? They’re called the executors and their tasks include collecting in any outstanding debts to your estate, paying off any loans and IHT due and then paying out what is left according to your wishes. Many couples name their partner as executor, but it could be worth choosing a second one in case you should both die at the same time.
- Do I want to put my money into trust when I die to provide an income and capital for my dependants? If you do, consider getting financial advice about the best trust to use.
- Who will look after the trust? A trustee, as they’re known, can either be a family member or friend or a professional such as a solicitor or financial adviser.
Gifting it away
The taxman allows you to make a number of small gifts each year without creating an IHT liability. Remember, each person has their own allowance, so the amount can be doubled if each spouse or partner uses their allowances.
You can also make larger gifts but these are known as Potentially Exempt Transfers (PETs) and you could have to pay IHT on their value if you die within seven years of making them. See Taper Relief for the amount you could owe.
Any other gifts made during your lifetime which do not qualify as a PET will immediately be chargeable to IHT.
These are called Chargeable Lifetime Transfers (CLT) and an example is a gift into a Discretionary trust.
The taxation rules of CLT’s are quite complicated and you should speak to a tax adviser if you are considering a CLT.
If you make a gift to someone but keep an interest in it, it becomes known as a ‘Gift With Reservation’ and will remain in your estate for IHT purposes when you die. For example, if you gave your son your house, but continued to live in it without paying a market rent, it would be considered a Gift With Reservation. But if you continued to live there and paid him a market rent each month, it would become a Potentially Exempt Transfer and move out of the IHT net provided you survived for seven years. However, your son would be liable to pay income tax on the rent he received.
The taxman lets you give the following as exempt transfers:
- Up to £3,000 each year as either one or a number of gifts. If you don’t use it all up one year you can carry the remainder over to the next tax year. A tax year runs from the 6 April one year to 5 April in the next year.
- Gifts of up to £250 to any number of other people – but not those who received all or part of the £3,000.
- Any amount from income that is given on a regular basis provided it doesn’t reduce your standard of living. These are known as gifts made as ‘normal expenditure out of income’.
- If your child is getting married you can gift them £5,000, if a grandchild or more distant descendent is getting married £2,500 and a friend or anyone else you know £1,000.
- Donations to charity, political parties, universities and certain other bodies recognised by the taxman (HM Revenue & Customs).
- Maintenance payments to spouses, and ex spouses, elderly or infirm dependant relatives and children under 18 or in full-time education.
There are certain other gifts that can qualify for relief from IHT. These can include gifts of a small business, sole trader enterprise or partnership and shares in companies listed on the smaller more risky stock exchange, the Alternative Investment Market (AIM).
Farmers can also gain up to 100% relief from IHT when making gifts of certain agricultural land or farm buildings. But the rules in both these situations, known as business and agricultural relief respectively, are complex and you’d be best to seek expert advice before gifting anything away.
Members of the armed forces killed in action or whose death is hastened by injuries sustained on active duty are also exempt from IHT.
Many people would like to make gifts to reduce IHT but are concerned about losing control of the money. This is where trusts can help. The rules changed in 2006 making some of them less tax effective, as a small minority will require you to pay IHT even before you have died, but they’re still worth considering. When talking about trusts, you will hear the terms:
- Settlor – the person setting up the trust.
- Trustees – the people tasked with looking after the trust and paying out its assets.
- Beneficiaries – the people who benefit from the assets held in trust.
There are now three main types of trusts. Any number of different types of investments can be held in a trust so you may want to seek expert financial advice to decide which is best for you.
- Bare (Absolute) trusts. With a bare trust you name the beneficiaries at outset and these can’t be changed. The assets, both income and capital, are immediately owned and can be taken by the beneficiary at age 18 (16 in Scotland).
- Interest in possession trusts. With this type of trust, the beneficiaries have a right to all the income from the trust, but not necessarily the capital. Sometimes, a different beneficiary will get the capital – say on the death of the income beneficiary. They’re often set up under the terms of a will to allow a spouse to benefit from the income during their lifetime but with the capital being owned by their children. The capital is distributed on the remaining parent’s death.
- Discretionary trusts. Here the trustees decide what happens to the income and capital throughout the lifetime of the trust and how it is paid out. There is usually a wide range of beneficiaries, but no specific beneficiary has the right to income from the trust.
A few trusts will now have to pay an IHT charge when they are set up, at 10 yearly intervals and even when assets are distributed. A financial adviser or other tax expert will be able to explain the exact tax implications of your actions and advise on the right type of trust to set up.
If you don’t want to give away your assets while you’re still alive, another option is to take out life cover, which can pay out an amount equal to your estimated IHT liability on death. Make sure you write the policy in trust, so that it pays out outside your estate.
You can choose a:
- Term policy – which runs for a fixed number of years
- Whole of life policy – which as the name suggests pays out when you die regardless of how long that is.
Policies written on a joint life second death basis – paying out when both of the couple are dead – can be the most cost efficient way of mitigating an IHT liability.
When choosing a whole of life plan, look for one that has no investment element – so you only pay for the life cover – not unwanted savings.* There are however some companies that offer guaranteed acceptance, regardless of the state of your health, for small amounts of cover – typically up to £15,000. You may have to pay more if your health isn’t good.
* Bear in mind that if you are in poor health or are very old you may not be able to take out a plan.
On your death
When you die, your estate has to be distributed one way or another. If you have a will, your executors have to gain a Grant of Probate in England and Wales or Northern Ireland (a Grant of Confirmation in Scotland). If there’s no valid will, or the named executors in the will are unwilling or unable to carry out their duties, a Grant of Letters of Administration is needed. This is known as dying intestate.
If the estate is worth less than £5,000 or all assets are jointly owned and pass to the surviving owner then Probate, Confirmation or Letters of Administration may not be needed.
If IHT is due, the executors or administrators normally have to pay at least some of it before a Grant is issued.
Once a Grant has been gained, the executors or administrators have to:
- Work out the assets and liabilities of the estate.
- Pay any outstanding loans and collect any outstanding debts.
- Work out and pay any remaining IHT due – or make arrangements for it to be paid off over 10 years in the case of properties and certain other assets.
- Pay out the remaining assets in accordance with the will or the rules of intestacy.
What could happen if you don’t write a will
The government lays down strict guidelines on how money is to be paid out if you die without making a will. These could mean that a long-term unmarried partner ends up receiving nothing and the Crown gets all your estate.
IHT can be complicated and no one likes to think about their own mortality, so it is a subject that is easy to avoid. But a little financial planning now can mean that your family and friends get your money when you die, not the Chancellor and/or the Crown.