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Inheritance tax
Plan to legally save £100,000s on your estate
Updated 28 February 2023
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. The rules around inheritance tax can be hard to understand at first, but it's important to get your head around it. This guide walks you through everything you need to know.
How much is inheritance tax?
Inheritance tax is a tax on the 'estate' of someone who's passed away.
How much you pay depends on the value of the deceased's estate – which is worked out based on their assets (cash in the bank, investments, property or business, vehicles, payouts from life insurance policies), minus any debts.
Importantly, there is normally no tax to pay if:
- The value of your estate is below £325,000, OR
- You leave everything over £325,000 to your spouse, civil partner, a charity or a community amateur sports club
If neither of the above applies, your estate will be taxed at 40% on anything above the £325,000 threshold when you die (or 36% if you leave at least 10% of the value after any deductions to a charity in your will).
However, this £325,000 tax-free threshold might be even higher depending on your circumstances – in some cases it can be as high as £500,000, or even £1 million. We'll explain more on this below.
Why do we have to pay inheritance tax?
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 property 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 happens if I inherit my parents' home?
In the current tax year, 2022/23, no inheritance tax is due on the first £325,000 of an estate, with 40% normally being charged on any amount above that.
However, what is charged will be less if you leave behind your home to your direct descendants, such as children or grandchildren. This is because you will then have two tax-free allowances:
- £325,000 – this is the basic inheritance tax allowance, which still applies.
- £175,000 – since 2015 you've also been able to take advantage of something called the 'residence nil-rate band', commonly known as the 'main residence' band. This is an additional allowance you'll receive ON TOP of the existing £325,000 inheritance tax allowance if you pass on a main residence to your children or grandchildren.
This means inheritance tax might not be due on the first £500,000 of your estate (£325,000 + £175,000), depending on who you leave your home to. However:
- The £175,000 main residence allowance only applies if your estate is worth less than £2 million.
- On estates worth £2 million or more, the main residence allowance will decrease by £1 for every £2 above £2 million that the deceased's estate is worth.
- Your home won’t qualify for the £175,000 main residence allowance if it's in a discretionary will trust, even if the beneficiaries of the trust are your children or grandchildren.
An example may help...
Let's say you've got an estate worth £525,000. You've decided to leave your home to your children. This means no inheritance tax will be charged on the first £500,000 (£325,000 basic allowance + £175,000 main residence allowance). There'll be a 40% charge on the remaining £25,000, giving a total of £10,000 in tax (presuming you're not leaving anything to charity).
If you weren't leaving your home to your direct descendants, you'd pay nothing on the first £325,000 of your estate, and 40% on the remaining £200,000, meaning a total of £80,000 to pay in inheritance tax.
Are the rules different if I'm married?
There are special rules for married couples or those in civil partnerships – they state:
- 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 percentage of your allowance that you didn't use, meaning together a couple can currently leave £1 million tax-free (2 x £325,000 tax-free allowances + 2 x £175,000 main residence allowances).
This can sound complicated, so here's an example...
Mr and Mrs Youngatheart have assets worth £1 million between them. Mr Y dies first in 2022/23 – leaving everything to Mrs Y – so his £325,000 tax-free allowance is passed on, as well as his £175,000 main residence allowance. In total, this means Mrs Y may have up to a £1 million tax-free allowance: her allowance, plus her inherited allowance from her deceased husband.
You don't need to do anything to activate this – the executors of your will just need to send certain documents to HM Revenue & Customs (HMRC) within two years after your death – see HMRC's guidelines.
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Ways to cut your tax bill – including giving money away (as long as you live for another seven years)
Money given away before you die is still usually counted as part of your estate, UNLESS you live for a further seven years or more after making the gift. People you give gifts to will be charged inheritance tax (on a sliding scale up to a maximum of 40%) if you give away more than £325,000 in the seven years before your death – therefore early planning of how to pass on your assets is important.
If you make large lifetime gifts – in other words, you give gifts during your lifetime, not on your death – 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 slash your bill
There is 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 are inheritance tax-free. Any donations to charity given as part of your will are not subject to inheritance tax. Where the donation is equivalent to at least 10% of your estate, any inheritance tax payable is reduced to 36% from 40%. Gifts in wills raise £3.6 billion for charities each year, but many people are unaware that such donations can reduce their inheritance tax bill, according to Remember A Charity.
- You can give £250 each year to everyone you know. Gifts of up to £250 per person each tax year are excluded from inheritance tax (and are not counted towards the £3,000 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. However, you couldn't combine gifts on the same person – for example, if you've already gifted someone your £3,000 annual gift exemption, you couldn't then also give them this annual £250 gift.
- You can give away money from income without having to pay tax (as long as it doesn't affect your lifestyle). 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.
- Wedding gifts (up to a limit) are tax-free. If your son, daughter, grandchild, or anyone else is getting married then you're able to give them gifts without them 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).
- Helping fund your kids going to uni. You can contribute to your children's living costs and tuition fees if they choose to go to university, which can be in the £000's. There are no limits to the amount you can give, as long as they continue in full-time education or training.
What constitutes a gift?
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 home, yet trying to give half of this to your children won't work if you continue to live in it.
Many gifts are valid ways of reducing your inheritance tax bill. Yet if any are given conditionally (barring a wedding gift), with the intention of receiving something in return, they could fail to work, so watch out.
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