Inheritance Tax (IHT) is something many of us have heard of, but understanding exactly how it works can feel daunting. Whether you’re thinking about the future for yourself or your loved ones, understanding the basics of IHT is an important step in planning for your financial future. In this guide, we’ll explore how inheritance tax works in the UK, explain key allowances and exemptions, and discuss some general strategies to help you better understand how the tax applies to estates.
What Is Inheritance Tax?
Inheritance Tax is a tax applied to a person’s estate after they pass away. An "estate" refers to everything the individual owns, including property, savings, investments, and possessions.
Currently, in the UK, IHT is usually charged at 40% on the value of the estate above a tax-free threshold known as the nil-rate band. For the 2024/2025 tax year, this threshold is £325,000. In other words, if the total value of an estate is below £325,000, there will be no IHT to pay. Anything above this amount is subject to the tax. However, when assessing the value of your estate you also have to add back in any non exempt gifts you made in the previous seven years.
The tax is generally paid by the estate itself, rather than the beneficiaries directly. However, it must be settled within six months of the person’s death to avoid interest charges.
When Is Inheritance Tax Paid?
Inheritance Tax applies to estates that exceed the nil-rate band threshold. If the estate is worth less than £325,000, no IHT is due. However, if the value of the estate exceeds this threshold, the tax is payable on the portion above it, subject any any gifts made in the previous seven years.
The executor of the will or personal representative is responsible for paying IHT. They use funds from the estate to settle the bill with HM Revenue & Customs (HMRC). If the estate includes assets that take time to sell, such as property, arrangements can sometimes be made with HMRC to pay the tax in instalments.
Key Allowances and Exemptions
Fortunately, there are several allowances and exemptions in place that can reduce or eliminate the amount of IHT payable on an estate. These are worth understanding if you want to ensure that your estate is managed as effectively as possible.
1. The Nil-Rate Band
The nil-rate band is the baseline tax-free threshold of £325,000 for all individuals. If the value of an estate is below this amount, no IHT is payable subject to any gifts made in the previous seven years.
For married couples or those in civil partnerships, unused portions of the nil-rate band can be transferred to the surviving partner. This effectively doubles the allowance for the couple, meaning up to £650,000 of their estate could be tax-free.
2. Residence Nil-Rate Band (RNRB)
Introduced in 2017, the residence nil-rate band provides an additional tax-free allowance if you leave your primary residence to your direct descendants, such as children or grandchildren. For the 2024/2025 tax year, the RNRB is £175,000 per individual.
When combined with the standard nil-rate band, this means a married couple could potentially leave up to £1 million tax-free to their children or grandchildren if their estate includes a family home. However should the value of your estate exceed £2m the RNRB allowance will reduce by £1 for every £2 the £2m threshold is exceeded.
3. Gifts and the Seven-Year Rule
In the UK, you can give away assets during your lifetime, and these may not count towards your estate for IHT purposes. This is subject to the seven-year rule, which means that gifts made more than seven years before your death are exempt from IHT. However, gifts made within seven years may still be subject to tax, depending on the value of the gift and when it was given.
There are also certain types of gifts that are exempt from IHT regardless of the seven-year rule. These include:
Wedding or civil partnership gifts: Parents can give up to £5,000, grandparents up to £2,500, and anyone else up to £1,000, tax-free for these events.
Annual exemption: You can give away up to £3,000 each tax year without it being added to your estate.
Small gifts exemption: You can give up to £250 to as many individuals as you like each year.
4. Spouse and Civil Partner Exemption
Assets left to a spouse or civil partner are exempt from IHT. This means that you can pass your entire estate to your partner without any tax being due. Additionally, any unused nil-rate band or residence nil-rate band can be transferred to the surviving partner, potentially doubling their tax-free threshold.
5. Charitable Donations
If you leave part of your estate to a registered charity, it will not be subject to IHT. Additionally, if you leave more than 10% of your estate to charity, the IHT rate on the rest of your estate is reduced from 40% to 36%.
Understanding the Recent Changes
If you’re concerned about the impact of IHT on your estate, it’s helpful to explore resources and strategies to manage tax liabilities.
The seven-year rule and annual exemptions provide opportunities to explore how gifting might reduce the taxable value of an estate. Learning how to use these allowances effectively can make a difference.
Trusts are another tool worth exploring. They allow you to place assets outside your estate while maintaining some control over how they are used. Different types of trusts work in different ways, so it’s important to research which might suit your needs.
Leaving a portion of your estate to charity not only supports a cause you care about but could also reduce the overall tax rate applied to your estate.
4. Reviewing Your Estate Regularly
As tax rules and personal circumstances change over time, regularly reviewing your estate can help ensure it aligns with your wishes and current regulations.
Final Thoughts
Inheritance Tax might seem complex, but understanding how it works can give you more confidence when planning your estate. By learning about allowances, exemptions, and recent changes to the rules, you can make more informed decisions. Always take the time to review your estate and research strategies that align with your personal circumstances. By planning ahead, you can help ensure your loved ones are taken care of while minimising the tax burden on your estate.
FAQs
1. What is the current inheritance tax threshold?
The current nil-rate band for IHT is £325,000. The residence nil-rate band can add up to £175,000, potentially increasing the tax-free allowance to £500,000 for individuals.
2. Who is responsible for paying inheritance tax?
The executor of the will or personal representative of the deceased is responsible for settling the IHT bill. The tax is usually paid from the estate’s funds.
3. Are pensions included in inheritance tax?
At the moment, most pensions are not included in IHT calculations. However, from April 2027, most pension funds will be included as part of the estate.
4. Can inheritance tax be reduced?
Yes, it’s possible to organise your estate in a way that manages IHT liability. This could include learning about gifting allowances, exploring trusts, or utilising charitable exemptions
5. Should I seek professional advice?
While not mandatory, speaking with a financial planner or estate specialist can help you better understand IHT rules and plan accordingly.
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