A Guide to Inheritance Tax
When a loved one passes away, the last thing that we want to think of are the tax implications of their estate. Sadly however this is a reality and in the paragraphs below we will try to explain the implications of the UK’s inheritance tax regime and what it means for you and your loved ones.
What and How Much is Inheritance Tax?
Simply put, Inheritance Tax (IHT) is a tax on the estate of someone who has passed away and includes all property, possessions and moneys left. So how much will become liable upon the passing of a loved one?
There is normally no tax to be paid if:
- The value of the estate falls below the Nill Rate Band (NRB) of £325,000
- Everything as outlined above or above the threshold is left to your spouse or civil partner
- Everything above the threshold is left to an exempt beneficiary, for example a charity
Whilst only 4-5% of UK households pay IHT, if the value of your estate is above the NRB, then the part of your estate above the threshold might become liable for tax at the rate of 40%.
For example – if the estate is worth £525,000 and your IHT threshold is £325,000, then the tax charged will be on the £200,000 (£525,000 – £325,000) threshold. The calculated tax will be £80,000 (40% of £200,000). The NRB is fixed at £325,000 until 2021, but your NRB might be increased if you’re widowed or a surviving civil partner. Couples can transfer any unused NRB when the first person died to the survivor.
This can also double the amount of NRB available up to £650.000 – this extra transferable element is known as Transferable Nil Rate Band (TNRB).
Also known as the Residence Nil Rate Band (RNRB) – the ‘home’ allowance has recently been introduced recently. The RNRB is on top of the NRB and the TNRB. To be eligible you must pass your home or a share of it to your children or grandchildren. This includes step-children, adopted children, foster children but not nieces, nephews or siblings.
This table shows the increases of the RNRB and the potential combined allowance:
|Tax Year||Resident Nil Rate Band (£)||Nil rate band (£)||Combined allowances|
After 2020/21, the RNIB will rise in line with the Consumer Price Index (CPI). There is a tapered withdrawal of the home allowance if the overall value of your estate exceeds £2 million. Provided certain conditions are met, the allowance gives you an additional allowances to be used to reduce any IHT liability against your home.
You may also be able to use any unused RNRB from your spouse or civil partner’s estate if you’re widowed or a surviving civil partner. This can double the amount of RNRB available. Find out more about transferring unused Inheritance Tax thresholds on Gov.uk. You can also find out more about the Residence Nil Rate Band and transferring unused RNRB on Gov.uk.
Who Pays Inheritance Tax?
If there is a will present, it’s usually the executor of the will who arranges to pay the Inheritance Tax (IHT).If there isn’t a will, it’s the administrator of the estate who does this. Whilst this is the norm, there may be exceptions and IHT can be paid from funds within the estate, or from money raised from the sale of the assets.
However, it is common that most IHT is paid through the Direct Payment Scheme (DPS). This means in reality that if the person who died had money in a bank or building society account, the person dealing with the estate can ask for all or some of the IHT due to be paid directly from the account through the DPS.
Sometimes the person who died has left money to pay IHT. Normally this is arranged through a whole-of-life insurance policy, which remains in force until the policyholder’s death, as long as the premiums are paid Payments from a life insurance policy could be subject to IHT. But, by writing the policy in Trust, the tax should be avoided. This way you also avoid going through the often-lengthy probate process.
Once the tax and debts are paid, the executor or administrator can distribute what remains of the estate.
Working Out the Value of Your Estate
Valuing an estate can be tough but to work out the basis of your estate you will need to:
- List out all the assets and work out their value at the date of death
- Deduct any debts and liabilities
Remember to always keep your physical and digital records of how you worked it out, such as estate agent’s valuation. The HMRC can ask to see records up to 20 years after Inheritance Tax (IHT) is paid so it prudent to keep your records to hand.
Assets to include items such as money in a bank, property and land, jewellery, cars, shares, a pay-out from an insurance policy and jointly owned assets.
Gifts also need to be included, such as cash or other assets, if they were given away in the seven years before the person died and you’ll also need to include any gifts given before this period if the person who died continued to benefit from the gift. These are also known as ‘gifts with reservations of benefit’. For example, they gave away their house but continued to live in it.
Also important to remember is that Debts and liabilities reduce the overall value of the deceased’s chargeable estate – in this case think about items such as household bills, mortgages, credit card debts, and, in general, funeral expenses. However, any costs incurred after death, such as solicitor’s and probate fees, can’t be deducted from the estate’s value for IHT purposes.
When do you have to pay Inheritance Tax?
If you need to pay Inheritance Tax (IHT), you’ll need to get an IHT reference number at least three weeks before you make a payment – This can be done by post or online.
Inheritance Tax (IHT) must also be paid by the end of the sixth month after the person’s death. If the tax is not paid within this timeframe, HMRC will start charging interest. The executors can choose to pay the tax on certain assets, such as property, by instalment over ten years, but the outstanding amount of tax will still get charged interest.
If your estate is likely to incur IHT, it’s a good idea for your executor to pay some of the tax within the first six months of death, even if they haven’t finished valuing the estate. This will help the estate reduce the interest that it could be charged if it takes longer to sell the assets to pay off the debts and taxes. If the executor or administrator is paying the tax from their own account, they can claim it back from the estate.
HMRC will also refund the estate if it has overpaid IHT once probate has been given. Probate is the right to deal with the deceased person’s property, money and possessions. In Scotland this is called confirmation.
If you have been appointed executor or administrator of the estate you will need to complete and send in an account of the estate within a year of the death to avoid a penalty.
How can I Reduce the Overall Amount of IHT?
Trying to reduce how much IHT is due on an estate is incredibly complicated and required expert advice, but you can reduce how much tax is paid by:
- Leaving a legacy to charity
- Leaving your estate to your spouse or civil partner
- Placing your assets into a trust for your heirs
- Regularly giving away up to £3,000 a year in gifts to loved ones
- Paying into a pension instead of a savings account
Inheritance Tax Gifts & Exemptions
Some gifts and property are exempt from Inheritance Tax (IHT), such as wedding gifts and charitable donations. Relief might also be available on certain types of property such as farms and business assets.
If the person who died gave a gift in the seven years before they died, it’s counted as part of the estate, and likely to incur IHT.
How much tax is due depends on the value of the gift, when it was given and to whom.
Using Life Insurance to Pay Inheritance Tax
Taking out a life insurance policy to pay some or all of an Inheritance Tax (IHT) bill, can make things easier on your family when it comes to sorting out your estate after your death.
It can help protect your home and other assets from having to be sold to pay an IHT bill, which must usually be paid before probate is granted. This gives you the peace of mind you’re not lumbering your family and friends with a hefty tax bill to pay when you pass away.
Normally, IHT needs to be paid before probate can be issued. But, where property is concerned HMRC may accept staged payments until the property is sold – a bank also might release money if its paid direct to HMRC to pay an IHT bill.
Most life insurance policies will count as part of the estate unless your policy is written ’in trust. This means any money is paid out to your beneficiaries and not to your legal estate. So any payout will not count towards your threshold and won’t be subject to IHT. This would avoid a lengthy probate process, so your beneficiaries will get their money much more quickly.
A whole-of-life insurance policy is often used for this purpose, which remains in force until the policyholder’s death, provided you continue paying the premiums. Estate and tax planning can be complicated, so it’s well worth getting advice to help you make the right decisions for your situation.
If you’re thinking of using life insurance to pay IHT, there are two types of policy you can take out:
· Whole of life policy
· Term Insurance Policy
Please note: If you gift assets away to loved ones other than spouses, there’s an additional risk that if you were to pass away within 7 years they could be left with a large tax bill. This bill will often fall on the person who received the gift rather than the estate.
What Other Taxes do my Heirs Have to Pay on their Inheritance?
Your estate is only distributed after debts (if any) and Inheritance Tax (IHT) are paid.
Depending on what they inherit, your heirs might also incur:
- Income Tax – if what they inherit produces a regular income (e.g. share dividends or rent from a property)
- Capital Gains Tax – if they sell their inheritance (e.g. property) for more money than what it was worth when you died. How much they have to pay depends on whether they pay Income Tax at the basic or higher rate.
We would always recommend that you speak to a tax adviser or solicitor for help in working this out.