What is Inheritance Tax, and how is it applied?

inheritance tax IHT

As the well-known saying puts it, the only two certainties in life are death and taxes, which is definitely where inheritance tax (IHT) comes in – and in more ways than one! But what exactly is IHT, how is it applied, and is there anything you can do to mitigate the effects of this on your estate?

Inheritance tax is the amount the government taxes what you leave behind in your estate after any allowances are deducted. Your estate is comprised of your assets which includes any cash you have in the bank at the time of your death, any property or business you own, your investments, payments from insurance policies, vehicles you own, and other tangible assets.

How much tax do you pay?

Your estate won’t be taxed at all if it’s valued at less than £325,000, referred to as the nil rate band. This means a couple could leave an estate worth £650,000 before it attracts IHT. Anything above these thresholds is taxed at 40%, or 36% if 10% of the estate has been left to a charitable organisation.

Meanwhile, a new Residence Nil Rate Band (RNRB) or ‘main residence’ allowance introduced in April 2017 means there is now additional relief.

How does the new rate band work?

The new allowance only applies to your ‘main residence’ and where the recipient of the property is a direct descendant including your children, step-children and grandchildren. The new allowance, which is on top of the existing allowance, is being phased as follows:

  • £125,000 for the 2017-18 tax year
  • Rising by £25,000 each year until 2020.
  • By 2020 the total allowance will rise to £500,000

This means the total allowance for the 2017-18 tax year is £450,000 (single allowance) or £900,00 for a couple. When one partner (husband, wife, civil partner) dies, his or her allowance is passed on to the surviving partner.

By 2020 the tax-free allowance will be £500,000 (£325,000 plus £175,000) for singles and £1 million ( 2 x £325,000 plus 2 x £175,000) for couples.

In other words, by tax year 20-21, homes valued at £1million will not attract IHT if all the eligibility conditions are met.

Tax will then be applied at the 40% rate on the amount above the £1million threshold up to £2 million, when a different formula is applied.

So what about gifts?

You can gain some relief from IHT by way of making a gift, although how this is treated will depend on the amounts involved and when the gift is made. Sums of money you give away before you die may still be subject to IHT if you pass away within seven years of making the gift. If you decide to gift your home to someone as a way of avoiding IHT, the seven year rule will still apply.

If you make a so-called gift with reservation – signing your house over to your son or daughter while still living in the house yourself – the value of the home will continue to be treated as being in your estate. It’s also important to note that gifts made in to a trust are subject to IHT.

All of the above are instances where you should seek specialist advice before deciding to gift large sums or property.

Gifts that are exempted

Certain other gifts are not subject to the seven year rule and won’t incur IHT. These include:

  • You can gift £3,000 every tax year without it being counted as part of your estate and subject to IHT
  • Gifts made to groups or organisations with charitable status are IHT free
  • Money left to a political party is not subject to IHT
  • Gifts of up to £250 to a single recipient per tax year are excluded from IHT and will not be considered as part of your annual gift exemption
  • Gifts to a spouse or partner, if they live permanently in the UK, are not subject to IHT
  • Marriage gifts are tax free, limited to £5,000 for a gift as a parent, £2,500 as a grandparent, and £1,000 from anyone else
  • Wedding gifts are only exempted if the wedding goes ahead

Other exemptions

People exempted from IHT include those serving in the armed forces, police, fire service, paramedics, and aid and humanitarian workers. The exemption also applies even if you have left the service but your death is hastened by an injury sustained while employed in one of these roles. If you own property that is considered part of a working farm, a percentage of the value may also be exempt from IHT.

Seek financial advice

The above is meant as a general guide only and you should always seek professional advice before deciding to gift large sums of money or dispose of other assets for tax purposes.