Inheritance tax can cost loved ones hundreds of thousands in the event of your death, yet it's possible to legally avoid huge swathes of it, or possibly pay none at all. The most important thing to do is examine whether you’ll pay and what to do about it; and this quick Q&A briefing is here to do just that.
What is inheritance tax?
A. When you die, the Government assesses how much your estate is worth. This includes the cash you have in the bank or in investments, and any property or business you own, then debts are deducted. If this exceeds the inheritance tax threshold set by the Chancellor, you (or technically your estate) will pay tax at 40% on the extra when you die. This is reduced to 36% if you leave at least 10% to a charity.
Dealing with it is one of the biggest single MoneySaving things you can do, as some simple actions can save you £100,000s. Yet sadly many people ignore it, either not wanting to consider the future or simply unable to broach it with relatives for fear of embarrassment or seeming grasping.
It's time we ended that. As Benjamin Franklin said, the only things that are certain in life are death and taxes, and this touches on both of them. So, whether you stand to inherit or leave the money, it's time to sit down and tackle these issues with your family as a grown-up. Don’t try and couch it in soft terms, the easiest way is to be matter-of-fact and go for it head on.
Why do we have to pay it?
A. The politics of inheritance tax are among the most controversial around; just ask the pre-Revolution French aristocracy!
The idea is that without it you perpetuate inherited wealth, so the children of the rich stay rich. Inheritance tax redistributes income so some of the money goes to the state to be distributed for the benefit of all. The argument against it is that when money’s earned tax is paid at the time, so to pay tax on it again isn't fair.
After years of rocketing house prices, many more people have been caught by the inheritance tax threshold, raising it higher up the agenda. Yet, whatever your views politically, inheritance tax is a financial fact, so it makes MoneySaving sense to know how it will affect you, and whether you can soften the blow.
What’s the nil-rate threshold?
A. Everyone is allowed to leave up to a certain amount without their inheritors needing to pay tax on it. The amount is set by the Government and is called the nil-rate band, because it’s the amount you pay a ‘nil-rate’ of inheritance tax on.
The inheritance tax threshold means everyone is able to leave £325,000 completely tax-free in the 2013/14 tax year. This limit has been frozen until at least 2017/18, when the Government will look again at whether to increase it. Above that amount, anything you leave behind is subject tax of 40% (or 36% if you leave at least 10% of your assets to a charity).
So for example, if you leave behind assets worth £500,000, your estate pays nothing on the first £325k, and 40% on the remaining £175k – a total of £70,000 in tax - if you are not leaving anything to charity.
Does this change if I’m married?
A. When you die, any assets left to your spouse or registered civil partner, provided they’re UK-domiciled, are exempt from inheritance tax. On top of this, your partner’s inheritance tax allowance is increased by the amount you didn’t leave to others, meaning together a couple can currently leave £650,000 tax-free.
This can sound complicated, so here’s an example:
Mr and Mrs Youngatheart have assets worth £800,000 between them. Let’s say Mr Y dies first, and leaves £200,000 to their children, the little Youngathearts. The remaining £125,000 of his nil-rate allowance will pass on to Mrs Y, giving his wife an allowance of £450,000.
When she passes away, with assets of £600,000, as Mr Youngatheart didn’t use his full nil-rate allowance she’ll owe 40% on everything above £450k, meaning £60,000 (forty percent of £150,000) will be payable in tax, leaving all the rest (£540,000) to the little Youngathearts.
Has it always worked this way?
A. No. Prior to October 2007 leaving everything to a spouse could be tax-inefficient. When the second spouse died, anything over £300,000 of joint assets was exposed to the taxman’s cold fingers, effectively meaning one partner had wasted their tax-free allowance.
It was possible to get around this by strategically leaving money to other family and friends, making sure that both partners got the full benefit of their allowances. Many people set up ‘discretionary trusts’ in their wills so that the first spouse to die got the benefit of the nil-rate band. This planning still works, but because the rules have changed it is no longer necessary.
What if my partner died before the rules changed?
A. The Government has said the newer rules are backdated indefinitely. This means if your partner didn’t take up all of their tax-free allowance at the time of their death, you are eligible to use some of it when you pass away.
You do not need to do anything to activate this - it's a grim thought but the executors of your will need to send certain documents to HMRC after your death - see HMRC's guidelines.
The key to how much extra you get relies on the proportion (not the amount) of the allowance that your spouse used. If your partner died in early 2008 and used 50% of the nil-rate allocation at the time of their death, then you will get 50% of the current allowance (ie, 50% of £325,000) in addition to your personal £325,000.
An example should help explain this:
- Let’s say Mr Youngatheart had passed away some years before Mrs Youngatheart, back when the nil-rate allowance was only £250,000. He gave £50,000 to each of his three children, meaning £150,000 had been used – 60% of his allowance. All the rest went to Mrs Youngatheart.
When she dies, of course she can now pass on £325,000 free of tax due to her own allowance. Yet she can also pass on the unused amount of Mr Youngatheart’s allowance. He didn’t use 40% of his, so she gets another 40% of the current nil-rate amount, ie, £130,000, without paying tax. This means her total nil-rate band is now £455,000.
Can I reduce the bill in any other way?
A. Money given away before you die is still usually counted as part of your estate, hence subject to inheritance tax if you die within seven years of giving the gift. Therefore one golden rule is to try to survive more than seven years (vitamin tablets anyone?) - which means early planning of how to pass on your assets is important. Living longer is a good idea anyway!
If you make large lifetime gifts, the beneficiaries could take out life insurance against the potential inheritance tax bill. Most gifts into trust are now subject to inheritance tax even if made during your lifetime, but this is an area where you would need specialist advice.
However, even if you do die within seven years of making a gift, there are a range of other exemptions worth taking into account to help lessen the tax bill:
- Annual inheritance tax gift exemption. The first £3,000 given away each tax year is completely ignored as part of your estate and thus not subject to Inheritance Tax if you die. If you don’t use this in a year, you can carry it forward for one tax year (no more) and use it then.
- Gifts to charities and political parties are inheritance tax-free. Leaving money to that cats' home is at least efficient tax planning.
- Give £250 each year to everyone you know. Gifts of no more than £250 to any one recipient per tax year are excluded from inheritance tax (and are not counted toward the annual gift exemption). For example someone with 12 grandchildren could give each of them £250 annually as a birthday present and it wouldn't be counted as part of the estate. This soon helps chip away at the bill.
- Gifts from income. Inheritance tax is a tax on your assets. However if you have an income (pension or earnings for example) and you give money regularly from that which leaves you enough income not to affect your lifestyle, then it is exempt.
- Gifts on consideration of marriage. You'll love this one. If you give a gift that is conditional on an agreement of marriage or civil partnership - "marry my daughter and I will give you X thousand pounds" - then it's exempt. There are limits to this though: £5,000 for a gift from a parent, £2,500 from a grandparent, £1,000 from anyone else. However, remember this is not a simple wedding gift, that wouldn't count. It must be conditional.
- Woodland, heritage, farm and business. If you own an agricultural property that's part of a working farm, then a percentage may be exempt from tax. Similarly if you own woodland, those who receive it in your will can apply for the timber on it, but not the land itself, to be deemed exempt. Do check what happens when the timber is sold, as inheritance tax may apply at that time.
What constitutes a gift?
A. A gift must be a genuine unconditional gift that you will not gain from; something given to someone without any reservation, no nods, winks or mutual back-scratching. The biggest asset most people have is their house, yet trying to give half of this to your descendants won't work if you continue to live in it.
Many gifts are a valid ways of reducing your inheritance tax bill. Yet if any (barring the gift on consideration of marriage) are given conditionally, with the intention of receiving something in return, they could fail to work, so watch out.
Should I get advice?
A. Inheritance tax is clearly a huge area of MoneySaving. After all, you don’t want to be super-savvy all your life just to have most of what you’ve saved go to the taxman. If that’s what you’re worried about, there are a couple of extra things you should think about:
Make a will.
This is actually a really sensible step for anyone thinking about the perils of inheritance tax, and what happens to your money once you’ve gone.
There are many off-the-shelf will packages, yet there are also commonly free or cheap ways to get a solicitor to do it, giving you extra protection - read the Cheap Wills guide.
Get tax advice.
While for most things you should try to do it yourself as it's much cheaper, if you have sizeable assets then inheritance tax is one of the few occasions where paying for good professional legal or tax advice is well worth the money – a few hundred quid to save £100,000s.
Yet first of all, consider if you’re even caught by inheritance tax at all. If you and your spouse’s total assets are under £650,000 (so house value, savings, inheritance, and what’d be left from your pension), you shouldn’t pay the tax anyway, so there’s little point.
However, for those with bigger estates, an independent financial adviser may, depending on their qualification, be able to help (see the Financial Advice guide), but a solicitor or tax accountant is a better bet for more specialised info. Preferably find one who is a member of the Society of Trust and Estate Practitioners, take a look on the STEP and Chartered Institute Of Taxation websites.
Oh and finally, inheritance tax planning is important, but don't forget, the main thing is that you (or your parents) should have financial security in old age. Don’t sacrifice everything just to plan for someone else’s future. You’ve earned your money, so let it make you comfortable.