A Guide to Inheritance Tax

When a loved one has passed away, the last thing loved ones want to deal with is Inheritance Tax (IHT). But it’s a necessary process and your legal obligation to follow it through. It can be rather overwhelming to understand IHT and everything it involves, especially when you’re also going through a bereavement.

This is why many families opt to hire an accountant who is able to offer inheritance tax services, such as the ones here at RLTP Accountants. This helps to take the stress and pressure off of you whilst you go focus your attention on your loved ones. With this in mind, here’s a brief overview of inheritance tax and everything you can expect when the time comes.

An ‘estate’ refers to assets that are left behind by someone who has passed away

An estate is something that’s left behind by someone who has passed away. If they were married or in a civil partnership, then they’ll be able to leave their entire estate to their spouse or legal partner without having to pay inheritance tax. However, if an estate is left to other members of the family, or to friends, then it might be subject to inheritance tax. An estate can include:

  • A house or other owned properties
  • Savings and investments
  • Some pensions
  • Other assets
  • Value of life insurance policies in the name of the person who has died

Did you know? Not everyone is required to pay inheritance tax

There are certain instances where IHT doesn’t need to be paid. One of those scenarios is when the estate, when added together, is worth less than £325,000 (also known as the ‘nil-rate band’. If the combined estate comes to more than £325,000, then the total value of any assets that make up the estate over that specific amount will be subject to 40% IHT.

How can you work out how much an estate is worth?

Once the estate has been added together, which is something a high-qualified accountant will be able to do for you, then any and all outstanding debts need to be subtracted, including a mortgage, credit cards and any loans. Other deductions on the estate can also include:

  • Gifts made during their lifetime
  • Charity donations left in a will
  • The reasonable cost of the funeral

Questions to answer after the estate has been valued

Once the estate has been valued and deductions have been made, you’ll need to ask whether or not the estate will still be liable for 40% IHT. Therefore, once all the numbers have been finalised, you need to ask yourself the following questions:

Is the value of the estate less than £325,000?

If the answer is ‘yes’, then you do not need to pay any IHT at this time. However, you should still keep a close eye on the value of assets as there could be some changes between the person passing away and estate being sold off. If some assets go up, like the value of a house, then this could push the value of the estate past the £325,000 threshold. Likewise, the value of something could fall, pushing the estate even further below the £325,000 IHT band.

Is the value of the estate more than £325,000?

If the answer is ‘yes’, then your nil-rate band has been used up. This then means that the remainder of the estate will be subject to IHT. The amount of IHT can be reduced from 40% to 36% if at least 10% of its value is left to charity in your will. This is because donations made to charities in a will is not subject to any tax.

Does marital status affect inheritance tax?

In short, yes. Marriage or civil partnerships can affect whether or not an estate is subject to IHT. However, the estate will, eventually, have to succumb to IHT at some point. There are several rules that apply depending on your marital status and we’ll be discussing those below:

If you’re single

If the person was single and their estate is valued below £325,000, then you will not have to pay IHT on it. Anything over that amount will then be subject to 40% IHT, as already touched upon.

If you’re married or in a civil partnership

If the entire estate is left to a spouse or civil partner, then the entire thing can be transferred without having to pay any IHT. Leaving assets to a spouse will also not affect the nil-rate band. However, if the estate is passed onto anyone other than your spouse or legal partner, then it will be subject to 40% IHT if it’s valued at over £325,000. If the estate is left to the surviving spouse, it will be subject to IHT if it’s valued at over £325,000 once the widow or widower passes away as the estate can then only be left to other family members or friends.

If you’ve been widowed or are a widower

If a widow or widower has been left the entire estate, then the nil-rate tax band has not been affected. This means that, in theory, when combined, both yourself and your spouse or partner who has passed away can combine your unused nil-rate band to give a total of £650,000. This will then be applied to the value of your estate.

If you’re a couple who are not married

For tax purposes, this will be treated as though both are single. This means that you’ll each have a nil-rate band of £325,000 which cannot be combined together if one or the other passes away. The normal rates will apply, where if the estate is valued at over £325,000, it will be subject to 40% IHT. If it falls below £325,000, then IHT will not need to be paid.

What is the residence nil-rate band?

A nil-rate band is the amount of money an estate can be valued at before paying any IHT. This is the same for everyone, whether single or an unmarried couple. But it can become somewhat confusing if you aren’t sure of the details.

A residence nil-rate band applies to estates of people who have passed away after 6th April 2017. The estate must also be left to either children or grandchildren. The allowance reached the maximum of £175,000 per person if the death occurred after 6th April 2020. This equates to £350,000 per couple. If you add this to a couple’s combined nil-rate band of £650,000, then the overall nil-rate band comes to £1 million per couple. This is set to rise each year, in line with inflation.

Thanks to the rise in house prices, an increasing number of people are having to pay IHT on their estates. As it stands, the nil-rate band on IHT has stagnated at £325,000. According to Statista, the average price for a home in the UK is £292,118 as of July 2022. That, combined with assets and savings, an estate could easily get pushed past that £325,000 IHT band, assuming they had no outstanding mortgage.

The aim is to ensure married couples can pass on up to £1 million of assets without paying any IHT, this includes the value of a family home. However, there are some rules that need to be adhered to because not everyone will be able to claim the new allowance. Those rules include:

  • It only applies where the person who has passed away owned a property that was, at one time, their home
  • The property must be left to direct descendants, including children or grandchildren
  • It doesn’t apply if you don’t own the property
  • If the estate exceeds £2 million, then the nil-rate band will be reduced by £1 for every £2 by which the value of the estate goes above £2 million
  • Larger estates might not benefit from the residence nil-rate band
  • If a property was disposed of before 8th July 2015 and the ex-owner(s) is now living in a nursing home or with children, then they will not be able to benefit from the residence nil-rate band

Do pensions make up part of an estate?

Changes were made in relation to the way in which IHT applies to some pensions. This really depends on two things: the type of pension that’s been built up over a lifetime and how old the person was when they died.

The type of pension you have dictates if and how it becomes part of your estate

Aside from the State Pension, there are two other types of pensions or pension schemes available to British workers. Although one is now more prevalent than another, the two available pension schemes are as follows:

A defined benefit pension

This is when a fixed percentage of a final salary is payable to you over the remainder of your life. The benefit of that income belongs to you and, if you pass away, it can benefit your spouse or legal partner. However, your pension cannot be left to anyone else after you have died. It might be possible to trade the value of each payment for a cash lump sum, although this is often considered to be a highly-unattractive option so make sure you seek the help of a financial adviser before going down this road.

A defined contribution pension

This is when a worker has paid into a pension during their working years and are then given a pot of money that’s been accrued as a result at the age of retirement. One could choose to take up to 25% of the pot tax-free, using the remainder to purchase annuity. Annuity will give you an income for life, but it cannot be left to beneficiaries after your death.

As of 2014, it’s been possible for workers to “draw down” on a lump-sum pension pot under this scheme. People will use this to provide themselves with an income instead of purchasing an annuity. This lump-sum pension pot could be left to your beneficiaries if it’s not been drawn down completely when you die.

The age at which you pass away will affect things

Undrawn pension pots can be free from IHT. However, additional taxes will need to be paid by your beneficiaries when they draw down the fund after you have passed away. But the terms will differ depending on the age you are when you die:

If you die before the age of 75

Those who inherit your pensions if you die before the age of 75 will not have to pay income tax as it’s drawn down by your beneficiaries.

If you die after the age of 75

The amount of income tax that needs to be paid will depend on the income tax status of whoever it is that’s inheriting the pension, but only if you die after the age of 75. They’ll likely have to pay income tax at the standard rate when they draw any amount out. The common rates of tax are currently 20%, 40% and 45%.

Can I leave a gift to reduce the value of my estate?

Assets can be gifted to family and friends either in a will or before you die. However, this doesn’t automatically mean that it’s exempt from IHT. There are some things to be wary of so that you don’t get stung.

Some gifts are exempt from Inheritance Tax

Gifts between civil partners or spouses are IHT-free. The HMRC gives everyone an annual allowance of £3,000 a year, also known as an ‘annual exemption’. If you do not use your £3,000 allowance in full at the end of the year, it can be carried over the following year to give a total of £6,000. However, if you do not use the entire £6,000 alliance in that year, it gets wiped and you’ll be back to £3,000 a year thereafter.

For example, let’s say you didn’t use your £3,000 allowance in 2020 and in 2021 you now have a £6,000 allowance and you only use £2,000 of it, you won’t have a £7,000 allowance for 2022 (£4,000 + £3,000), it’ll go back down to £3,000.

Small gifts can also be made (up to £250) to as many different people as you like, but you won’t be able to use your annual exemption and the small gift exemption on the same person within the same year.

Wedding gifts are also tax-free depending on the relationship of the person who is getting married. If it’s your child, you can give up to £5,000 IHT-free. If it’s your grandchildren, you can give them up to £2,500 IHT-free. If it’s your spouse or civil partner, it can also be up to £2,500-free or up to £1,000 IHT-free for any other relation. Any gift between spouses is IHT-free as a general rule. IHT also cannot be paid if the gift has been left to one or more of the following:

  • Universities
  • National Trust sites
  • Political parties
  • National museums
  • Charities of any kind
  • Other institutions, such as housing associations

Some gifts are subject to Inheritance Tax

Also known as ‘potentially exempt transfers’, they are IHT-free if the person doing the gifting has survived for a minimum of seven years after the gift was given. If that person passes away within seven years of giving the gift, that gift will be included within their estate and there will be subject to IHT.

What is taper relief?

There is some relief which reduces the amount of IHT paid if the person survives between three and seven years after the gift was made. This is known as Taper Relief. Where seven years is IHT-free, anything above that will be subject to some tax:

  • If the person passes away between 0-3 years of giving a gift, then no taper relief applies and it’ll be subject to the full 40% IHT rate
  • If the person dies between 3-4 years of giving a gift, then a 20% relief rate will be applied
  • If the person passes away between 4-5 years of giving a gift, a 40% relief rate will be applied
  • If the person dies between 5-6 years of giving a gift, a 60% relief rate will be applied
  • If the person passes away between 6-7 years of giving a gift, a 80% relief rate will be applied
  • If the person passes away seven years (or longer) after giving a gift, then not IHT will need to be paid, providing a 100% relief rate

Should I keep a record of gifts I’ve made during my lifetime?

You’re not required by law to keep a track of the gifts you’ve made to your family and friends throughout your lifetime, although it can be extremely helpful to do so, either for yourself or your loved ones after you have passed away. When you die, any executors will have to account for any gifts you have made throughout your lifetime, focusing more on the last fourteen years of your life. If you keep detailed records, then this makes the process easier for those who are left behind.

What about equity release schemes?

Most people will find the bulk of the value of their estate tied up in their house and so they might choose to implement an equity-release scheme. This involves selling off a percentage of a property whilst still being able to live there. Alternatively, a mortgage can be taken out for the rest of their lifetime.

These types of schemes can reduce the value of an estate because the money is being repaid solely from the value of the house after you have passed away. This money can be used as retirement income or to make gifts to family or friends, which could greatly reduce the value of your taxable estate (provided you survive at least seven years after the gift has been made).

Can I set up a trust fund to avoid paying Inheritance Tax?

Trusts can be set up to ensure assets are given to beneficiaries in a quick and controlled way and without having to pay any IHT. Trusts are usually set up to make sure that assets are kept within the family for generations to come. It can also be set up for vulnerable beneficiaries whereby other family members will be responsible. One advantage of a trust, other than being IHT-free, is that they can be set up in direct accordance with your wishes. There are several different trusts available depending on what it is you want to get out of it:

  • If you want to leave assets to children or grandchildren who are not yet of age to receive them, so they’ll need to reach a certain age before it’s released to them
  • If you wish to impose restrictions on how the estate is allocated to children, grandchildren (beneficiaries) etc
  • If you want a specific person to receive an income form your assets during their lifetime but wish for the assets to be passed onto someone else, ultimately

There are some limitations when it comes to trust funds

They can be quite complicated to set up, but they do have their advantages. But where they might suit some families and instances, they can be quite limiting in other cases. There are, typically, four different types of trust fund available:

Discretionary trusts

  • Set up to provide a group of beneficiaries with money
  • Assets are outside of the estate, provided the person who set up the trust lives for at least seven years thereafter, for IHT purposes
  • IHT might be payable: at the outset, when trust assets are paid out to beneficiaries or every ten years (periodic charges)

Discount gift trusts

  • Involves someone making a gift to a trust whilst reserving the right to pre-agreed payments of capital, from the trust itself, during their own lifetime
  • Gift is valued after reliefs and discounts are applied based on the person’s health, sex and age, for IHT purposes
  • Value of taxable estate can be immediately reduced by the amount of discount applied to the gift to the trust, all whilst benefiting from regular payments from the trust throughout the course of their lifetime
  • Discounts are given as the trust will be paying set amounts to the owner for the rest of their life
  • If the amounts are not spent or used, they’ll be subject to IHT after the owner has died

Immediate post-death interest trusts

  • Ensures one beneficiary receives ‘life interest’ in the assets outlined in the trust
  • Could be the right to live in a house or receive rent from a property for the rest of their lifetime
  • Capital held in this trust must be passed onto different beneficiaries in the future
  • Assets in the trust are classed as part of the lifetime beneficiary’s estate, for IHT purposes
  • When the beneficiary dies, the capital/assets in the trust will be liable to IHT, unless their death estate is valued at less than £325,000

Loan trusts

  • A person sets up a loan trust with themselves as the trustee for the benefit of another person
  • The trustee makes a load to the trust which is repayable on demand
  • Loan capital can be invested to generate trust growth in the long-term
  • Any growth within the trust will then be exempt from IHT

Can I take out Life Insurance to offset Inheritance Tax?

There are two different lifetime insurance policies that can help with offsetting IHT: whole-of-life assurance and term insurance. Assurance covers you until you pass away with the insurance covering you only for a set amount of time.

A whole-of-life policy

With this policy, you specify the amount that should be paid out upon your death. This way your beneficiaries can use this lump sum to pay off any IHT that might be due, to the HMRC, without impacting the amount they’ll get from your estate.

A term policy

You should take out either a ‘level-term’ or a ‘decreasing-term’ policy. This means that a lump sum will be paid upon your death that will be given within a specific timeframe. This would be worthwhile if you’ve given away many gifts that add up to a considerable value within the last seven years and you’re concerned you won’t live for the full seven years to allow for it all to be IHT-free. This way, the policy will pay out an amount that’ll cover any IHT due on gifts made within the last seven years.

It’s important to note that the insurance policy will become more expensive the older you get and you might be subject to a health assessment before they’ll grant you cover. With this in mind, you should visit a financial adviser or add up how much it would cost over so many years versus actually paying the IHT bill owed on your estate. Sometimes, paying the 40% IHT is cheaper than taking out insurance to offset it.

What about an Inheritance Tax-free ISA?

ISAs will offer tax benefits over the course of your lifetime but it could prove to be problematic for your loved ones upon your death. If you’ve made full use of your allowances over the years, then there could be a substantial portfolio of Individual Savings Accounts (ISAs) that you’re now sitting on. However, ISAs are subject to IHT, which can be damaging for those who have been saving for most of their life. However, it’s important that you include your ISA as part of your estate. It’s important that you see a financial adviser to discuss the best plan of action so that your family pays as little IHT as possible when you die.

Making a will is highly-advised

No matter how big or small your estate is, it’s important that you make a will. This is the same if you’re married, unmarried, in a civil partnership or are single. This ensures that your assets go to who you wish, even if you want to leave the entire amount to charity. Without a will, and if there’s no one who can be traced to give your estate to, the entire thing will become property of the Crown.

Why should I make a will?

As already touched upon, it ensures the value of the estate goes to exactly who you want it to go to, whether it be friends, family or charity. It also prevents it from being taken by the government. Making a will will also make things easier for your loved ones as estranged family members could claim a stake in your estate and court hearings could occur. Avoid the stress and make a will, no matter how big or small your estate might be.

When should I make a will?

There’s no real timeframe in which you should write a will. Some don’t write one for years whereas others have one drawn up as soon as they’ve bought their first home or have surpassed a certain amount in their savings accounts. It’s a personal choice, but you should also note that they can be edited to account for any future children, grandchildren, nieces and nephews, for example.

What happens if I don’t leave a will behind?

As already touched upon, there are several things that can happen if you do not leave a will behind after you have died:

  • Your estate will not be split up or handed out in accordance with your wishes
  • If no close relatives are found, your estate will end up with the Crown
  • Estranged relatives could take your immediate relatives to court as they feel as though they’re entitled to a sum of your estate

RLTP Accountants are pleased to provide Inheritance Tax Planning services to customers throughout Derby, Nottingham and Leicester. We have a high-qualified, professional team of specialist accountants on hand who are dedicated to providing sterling customer service with knowledge and expertise which is second-to-none. For more information about how we can help you today, get in touch with a member of our expert team – we’re always happy to hear from you.