- Financial planning
- 5 minute read
Inheritance Tax (IHT) planning is a fundamental part of wealth management. By planning ahead, you can potentially save your family thousands of pounds in Inheritance Tax when you die and ensure that your wealth is preserved for future generations.
You can find more information in relation to IHT in our Inheritance Tax and Estate Planning Guide, which can be downloaded here.
What is Inheritance Tax?
Inheritance Tax is a tax on the estate of someone who has passed away.
Your estate consists of everything you own. This includes savings, investments, real estate, life insurance payouts, and personal possessions. Debts and liabilities are subtracted from the total value of your assets.
Every person in the UK currently has an Inheritance Tax allowance of £325,000. This is known as the nil-rate band (NRB).
What this means is that you don’t have to pay any Inheritance Tax if either:
- The value of your estate is below this £325,000 nil-rate band, or
- You leave everything above the £325,000 nil-rate band to your spouse, civil partner, a charity, or a community amateur sports club.
Note that if your estate’s value is below the nil-rate band, it still needs to be reported to HM Revenue and Customs (HMRC).
What are Inheritance Tax rates?
The standard Inheritance Tax rate is 40%.
This is only charged on the part of your estate that is above the £325,000 nil-rate band, however.
For example, if you leave behind an estate worth £750,000, the Inheritance Tax due will be £170,000 (40% of the difference between £750,000 and £325,000).
What are the Inheritance Tax rules for married couples?
If you are married or in a civil partnership, you are allowed to pass on your assets to your partner tax-free in most cases. The surviving partner is then allowed to use both tax-free allowances. Provided the first person to pass away leaves all of their assets to their surviving spouse, the surviving spouse will have an IHT allowance of £650,000.
How does passing on a home work with IHT?
You can pass on your home to your husband, wife, or civil partner tax-free when you die. However, if you leave the home to another person in your will, it will count towards the value of the estate.
In 2017, an extra allowance was introduced to make it easier to pass on your main residence to direct relatives (i.e. a child or grandchild) without incurring IHT. This allowance is known as the residence nil-rate band (RNRB).
The way the RNRB works is that there is a £175,000 allowance per person (for the 2020/2021 tax year) for those who pass on their homes to direct descendants. This is on top of the standard nil-rate band of £325,000.
This means that you can potentially pass on a total of £500,000 tax-free (£1 million for a couple) if you leave your home to a direct descendant.
Like the standard nil-rate band, unused elements of the residence nil-rate band are transferable to a surviving spouse or civil partner. This can potentially double the amount of RNRB available.
Note that there is a tapered withdrawal of the RNRB if the overall value of your estate exceeds £2 million. The withdrawal rate is £1 for every £2 over the £2 million threshold.
There are also qualifying conditions that need to be met to claim the RNRB allowance. If you are unsure about how the RNRB works, it’s a good idea to speak to a financial adviser.
Who pays the Inheritance Tax to HMRC?
If you have a will, it’s usually the executor of the will who arranges to pay your Inheritance Tax to HMRC. If you don’t have a will, the administrator of your estate will do this.
IHT can be paid from funds within the estate, or from money raised from the sale of the assets. To sell assets within an estate, however, you need Grant of probate, and this cannot be granted until the IHT bill is paid. One way to overcome this dilemma is to use an ‘executor’ loan to cover the IHT liability.
In practice, most IHT is paid directly from the deceased person’s bank account to HMRC through the Direct Payment Scheme (DPS).
Inheritance Tax planning: the first steps
Planning for Inheritance Tax will depend on your personal situation.
However, a good place to start is to estimate the value of your estate and calculate roughly how much IHT may be due when you die. One easy way to do this is by using an Inheritance Tax calculator.
Once you know the approximate value of your estate, you can then develop a plan to minimise your IHT liabilities.
Writing a will
One of the most important components of an Inheritance Tax plan is a will.
Without a will, your assets will be distributed according to intestacy rules, meaning that they may be liable to IHT that potentially could have been avoided.
In your will, you can appoint an executor. This is the person that will be responsible for handling your estate in the event of your death.
How to reduce your Inheritance Tax bill
There are a number of ways that you can reduce the size of your taxable estate during your lifetime and subsequently reduce your future Inheritance Tax liabilities. Here’s a look at six straightforward strategies to reduce your IHT bill.
Gift money while you are still alive
Gifting money while you are still alive is one of the easiest ways to reduce the size of your estate.
Under current rules, you can give away assets or cash worth £3,000 per year as gifts without this money being subject to IHT.
A Potentially Exempt Transfer (PET) is another way that you can reduce your IHT bill. Here, gifts of unlimited value are exempt from IHT as long as you survive for a period of seven years after making the gift. If you do not survive for seven years after making the gift, the gift will be subject to IHT.
Gifts that are made out of surplus income can also be free of IHT, as long as the gifts are made regularly and detailed records are maintained.
There’s also no IHT to pay on gifts between spouses or civil partners, as long as they live in the UK on a permanent basis.
Set up a trust
Trusts can also be an effective way of reducing IHT liabilities.
Setting up a Discounted Gift Trust (DGT) is one option to consider. A DGT allows you to invest a sum of money in order to reduce the amount of IHT you pay in the future, while retaining the right to fixed regular payments. A DGT can be a powerful estate planning tool for those who are looking to draw an income from their investments throughout their lifetime and then pass on a lump sum to their beneficiaries.
Bear in mind that the rules surrounding trusts are complicated, so, it’s a good idea to seek expert advice if you’re looking to use them.
Make use of pensions
Keeping money within a defined contribution pension can be another way to minimise IHT. Unlike other assets, your pension is not part of your taxable estate, meaning it is usually free of IHT. Keeping your wealth within a pension wrapper and passing this on to future generations can be an effective strategy.
If you die before the age of 75, your pension will be passed on tax-free. However, if you die after the age of 75, your beneficiaries will pay tax on the proceeds at their highest income tax rate. Your pension will not be covered by your will, so you will need to ensure that your pension provider knows who your nominated beneficiaries are.
Buy life insurance within a trust
Normally, the payout from a life insurance policy is included within your estate and subject to IHT. However, if the life insurance policy is placed within a trust, the proceeds can be paid directly to your beneficiaries rather than to your estate. This means that the payout will not be considered when IHT is calculated.
Business Relief / Agricultural Relief
Owning an asset that qualifies for Business Relief (BR) or Agricultural Relief (AR) can be another effective IHT planning strategy as these can be exempt from IHT. Provided the asset has been held for at least two years, it may be possible to receive Business Relief or Agricultural Relief of either 50% or 100%.
Leave money to charity
Finally, leaving money to charity can help reduce your IHT bill. If you leave money to charity, it won’t count towards your taxable estate. And if you leave 10% or more of your ‘net estate’ to charity, your estate can pay Inheritance Tax at a reduced rate of 36%, instead of 40%.
Inheritance Tax: it’s never too early to start planning
In conclusion, if you want to pass on as much of your wealth as possible, it’s a good idea to plan ahead for Inheritance Tax. It’s never too early to start exploring your options. With a careful plan, you can protect your assets from IHT and minimise the potential tax burden on your family.
To find out more or if you have any questions about Inheritance Tax planning, don’t hesitate to request a call back.
Please note that any tax benefits will depend on your personal tax position and rules are subject to change. The value of investments can go down as well as up, and you may get back less than you invested.