Sam | Edited by Johanna
Updated November 2017
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 inheritance tax and what to do about it; and this Q&A guide is here to help you do just that. This includes Government changes giving people an extra property allowance.
In this guide
What is inheritance tax?
Inheritance tax is the tax paid on assets (after inheritance tax allowances are deducted) left when someone dies.
As Benjamin Franklin said, the only things certain in life are death and taxes, and inheritance tax (IHT) touches on both.
How does inheritance tax work?
When you die, the Government assesses how much your estate is worth, then deducts your debts from this to give the value of your estate. Your assets include:
- Cash in the bank
- Any property or business you own
- Payouts from life insurance policies
The BIG question... how much tax do you pay?
Your estate will owe tax at 40% on anything above the £325,000 inheritance tax threshold when you die (or 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 seeming grasping.
IHT to be scrapped on up-to-£1m homes by April 2020
Former Chancellor of the Exchequer George Osborne revealed in July 2015's Summer Budget that he'd scrap the duty when parents or grandparents pass on a home worth up to £1 million (£500,000 for singles). This is being phased in gradually until April 2020.
However, the way this works in practice takes some explaining...
The basic allowance is unchanged
The current allowance whereby no inheritance tax is charged is on the first £325,000 (per person) of someone's estate – which is the value of their total assets they leave behind when they die. Couples can leave a home worth £650,000 without it attracting inheritance tax (singles £325,000). Above the threshold, the charge is 40%. This remains unchanged. What has changed is the introduction of a new 'main residence' band.
How does the new 'main residence' band work?
New for the 2017/18 tax year is the additional 'main residence' allowance. It is only valid on a main residence and where the recipient of a home is a direct descendant (classed as children, step-children and grandchildren). This is gradually being phased in as follows and is what you'll get on top of your existing allowance:
- For this tax year it's starting at £100,000 (meaning a total allowance of £425,000), rising by £25,000 each year till it reaches £175,000 (meaning a total allowance of £500,000) in 2020.
- So now the maximum that can be passed on tax-free is £850,000 for married couples or those in a civil partnership, £425,000 for others. For singles, this is made up of the existing £325,000, plus the extra £100,000. For couples, when the first one dies their allowance is passed to the survivor, so that £425,000 is doubled to £850,000.
- In 2020, the tax-free amount will rise to £1 million for couples (made up of £325,000 x 2 plus £175,000 x 2) and £500,000 for singles (made up of £325,000 plus £175,000), as the main residence allowance rises.
- On properties worth between £1 million and £2 million, inheritance tax will be paid as normal on the amount above the tax-free amount.
- On properties worth £2 million or more, homeowners will lose £1 of the 'main residence' allowance for every £2 of value above £2 million. So for a couple, properties worth £2,350,000 or more will get no additional allowance.
Who pays inheritance tax?
In the 2017/18 tax year, everyone is allowed to leave an estate valued at up to £325,000 plus the new 'main residence' band of £100,000 giving a total allowance of £425,000.
For estates valued under this their beneficiaries won't pay inheritance tax. 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 IHT on.
Above that amount, anything you leave behind is subject to 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 (assuming you have just one property), your estate pays nothing on the first £425,000, and 40% on the remaining £75,000 – a total of £30,000 in tax – if you're not leaving anything to charity.
Officially, the £325,000 limit has been frozen until at least 2020/21, while the additional main residence allowance will be phased in until April 2020.
Exemptions from inheritance tax
People in certain 'risky' roles are exempt from paying inheritance tax if they die in active service. Included in this are armed forces personnel, police, firefighters and paramedics, plus humanitarian aid workers.
Why do we have to pay IHT?
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.
Am I exempt if I'm married?
When you die, any assets left to your spouse or registered civil partner, provided they're living in the UK, are exempt from inheritance tax. On top of this, your partner's inheritance tax allowance rises by the amount of your allowance that you didn't use, meaning together a couple can currently leave £850,000 tax-free.
This can sound complicated, so here's an example:
Mr and Mrs Youngatheart have assets worth £900,000 between them. Let's say Mr Y dies first, and leaves £300,000 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 £550,000.
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 £550,000, meaning £20,000 (40% of £50,000) will be payable in tax, leaving all the rest (£580,000) to the little Youngathearts.
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 HM Revenue & Customs (HMRC) after your death – see HMRC's guidelines.
What if my partner died years ago?
These rules are backdated – so will apply if your partner died before October 2007. The key to how much extra allowance you get relies on the proportion (not the amount) of the allowance that your spouse used.
So, for example, if your partner died in early 2008 and used 50% of their nil-rate allowance at the time of their death, you will get 50% of the current allowance (ie, 50% of £425,000) in addition to your personal £425,000.
An example should help explain this:
Let's say Mr Youngatheart 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 £425,000 free of tax due to her own allowance. But 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, £170,000, without paying tax. This means her total nil-rate band is now £595,000.
What if I'm not married?
While transfers of property and other assets between married couples or civil partners don't attract inheritance tax, this isn't the case for unmarried couples.
If you're not married, but own assets jointly with another person, the situation gets complicated, especially where a residential property is involved. Your liability to pay IHT will depend on whether you and your partner own the property as 'joint tenants' or 'tenants in common' and whether there's a will.
If you're joint tenants (you both own all the property), and your partner's left you everything in the will, then if your partner's assets, including the property, exceed the £425,000 inheritance tax threshold, you'd have to pay it on any assets in the estate above that. After your partner's death, your property would then be owned by you in its entirety.
Even if your partner didn't leave a will, thanks to something called the 'right of survivorship', the property would still go entirely to you although the above inheritance tax rules would still apply.
However, his or her family would still have a claim to your partner's share of other assets such as insurance policies and pension investments.
What if we're tenants in common?
If you're tenants in common (you each own a specified percentage of the property), then it's more complex. If your partner's made a will leaving their share to you, any inheritance tax would be paid out of the estate by the executor before the bequests are shared out. You may end up having to pay IHT on the property, but it'd depend on the value of the rest of the estate.
If your partner's not made a will leaving his or her share to you, and you're tenants in common, then their share will go to your partner's relations. As an unmarried partner, you'd only be entitled to the share of the house you currently own.
It's especially important that if you own a property with someone who isn't your husband/wife or child, then you need to make a will describing exactly who benefits on your death.
Giving a gift? There's no tax to pay if you live a further seven years...
Money given away before you die is still usually counted as part of your estate, hence it's 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.
Other ways to cut your tax bill
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:
You can give £3,000 away each tax year inheritance tax-free
The first £3,000 given away each tax year is completely ignored as part of your estate and therefore not subject to inheritance tax if you die. If you don't give it away one 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.
You can 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.
How are gifts from your income treated?
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 in consideration of marriage are tax-free
If your son, daughter, grandchild, or anyone else is getting married then you're able to give them gifts without it being subject to inheritance tax.
There are limits to this though: £5,000 for a gift from a parent, £2,500 from a grandparent, £1,000 from anyone else. You need to give this gift on or shortly before the day of the wedding or civil partnership ceremony (and the marriage has to go ahead).
What if I own a farm?
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. If you plan to sell the timber, inheritance tax may apply at that time.
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 children 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.
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:
It's crucial to 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 our 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 it – spend £100s to save £100,000s.
But 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.
Free 30-60min inheritance planning session
VouchedFor, a site allowing you to search for local independent financial advisers, is running an offer – a free 30-60 minute session with a local independent financial adviser to discuss your inheritance plans.
Just follow this link*, enter your postcode, and contact your chosen adviser by phone or online to arrange your free session which you can use to ask questions and identify what steps you should take with your inheritance planning.
To make sure you get the most out of the session, it's a good idea to have a summary of your financial situation to hand – any savings, debt, incomings, outgoings – as well as details of existing wills, trusts and future plans.
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.