Plan to legally save £100,000s on your estate
Inheritance tax can cost loved ones hundreds of thousands when you die, yet it's possible to legally avoid huge swathes of it, or possibly pay none at all. Here's what you need to know.
In this guide
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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) – excluding the 'main residence' allowance (see below).
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 families ignore it, either not wanting to consider the future or simply unable to broach it with older relatives for fear of seeming grasping.
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, reaching a £1m exemption for couples in the tax year 2020/21.
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.
Introduced in the 2017/18 tax year, the additional main-residence allowance is technically called the 'residence nil rate band' or 'RNRB'. It's 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 allowance is part way through being gradually increased and is what you'll get on top of your existing allowance:
- For the tax year 2019/20, the allowance goes up to £150,000 (meaning a total individual allowance of £475,000) and it will rise again by £25,000 in 2020/21 when it reaches £175,000 (meaning a total allowance of £500,000).
- So in 2019/20 the maximum that can be passed on tax-free is £950,000 for married couples or those in a civil partnership, £475,000 for others. For singles, this is made up of the existing £325,000, plus the extra £150,000. For couples, when the first person dies their allowance is passed to the survivor, so that £475,000 is doubled to £950,000.
- By the 2020/21 tax year, 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 estates worth between £1 million and £2 million, inheritance tax will be paid as normal on the amount above the tax-free amount.
- On estates 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.
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Who pays inheritance tax?
For estates worth less than this, 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 in 2019/20 worth £500,000 (assuming you have just one property), your estate pays nothing on the first £475,000, and 40% on the remaining £25,000 – a total of £10,000 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.
The exemption also comes into play if a person who was injured on active service has their death hastened by the injury, even if they're no longer on active service.
Why do we have to pay IHT?
The politics of inheritance tax are controversial. 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, 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 proportion of your allowance that you didn't use, meaning together a couple can currently leave £950,000 tax-free.
This can sound complicated, so here's an example:
Mr and Mrs Youngatheart have assets worth £950,000 between them. Mr Y dies first in 2019/20 so his £325,000 tax-free allowance is passed on, as well as his £150,000 'main residence allowance'. In total, this means Mrs Y has a £950,000 tax-free allowance: her allowance, plus her inherited allowance from her deceased husband.
You don't 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.
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.
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 £325,000).
In addition, you get 100% of their main residence allowance ie. another £150,000, which they wouldn't have used because it wasn't available back in 2008. This is on top your own £475,000.
In such circumstances, 100% of the main residence allowance will be available for transfer unless the estate was worth more than £2 million and the allowance is tapered away.
An example should help explain:
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 was used – 60% of his allowance. All the rest went to Mrs Y.
When she dies, of course she can currently pass on £475,000 free of tax due to her own allowance (£325,000 + £150,000). But she can also pass on the unused amount of Mr Y's allowance free of tax. He didn't use 40% of his, so she gets another 40% of the current nil-rate amount, ie, £130,000, plus 100% of Mr Y's main residence allowance ie £150,000. This means her total tax-free allowance is currently £475,000 + £280,000 ie. £755,000.
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What if I'm not married?
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 inheritance tax threshold, you'd have to pay tax on any assets in the estate above that. After your partner's death, the 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 inheritance tax rules above would still apply.
However, your partner's family would still have a claim to his or her share of other assets such as insurance policies and pension investments.
If you're tenants in common (you each own a specified percentage of the property), 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 their share to you, and you're tenants in common, their share will go to their 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, you need to make a will describing exactly who benefits on your death.
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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:
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.
Leaving money to that cats' home is at least efficient tax planning.
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.
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.
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).
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.
This is a very 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.
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 to 60-min 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.
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