What to know about inheritance tax

Inheritances worth more than £325,000 are charged tax, and the bill can be substantial. Understanding how inheritance tax works ensures your heirs will receive the money or assets you plan to pass on.

Felicity Hannah Published on 30 June 2021.
What to know about inheritance tax

Although a lot of people worry about inheritance tax (IHT), the truth is that the overwhelming majority won’t ever have to pay it.

HMRC figures show that only one in 20 estates pays any IHT. Nonetheless, it’s still important to understand how it all works so that you can make sure you’re passing on or receiving as much of any inheritance as you can.

For those estates that do end up paying IHT, the bill can be substantial. In 2018/19, 27,000 estates paid a total of £5.4bn in IHT, averaging just under £200,000 each.

So what do you need to know about what some people cheerily call ‘the death tax’? Read our guide to get your key questions answered.

What is inheritance tax?

Very simply, IHT is a levy on money or assets you leave behind after you die.

It’s set at a rate of 40% after the tax-free allowance (known as the nil rate band), and it’s payable per estate rather than per person who inherits. That means you can’t reduce the bill by sharing it around more people and using up multiple allowances.

But the good news is the threshold for IHT is high so estates have to be worth a substantial amount before it is due, which is why the vast majority don’t pay it.

Who pays inheritance tax?

Everyone is allowed to pass on an estate worth up to £325,000 without having to pay any tax on it. However, if your estate includes property, you could get an additional £175,000.

Married couples and civil partners are also able to pass assets over to each other when one dies, tax free in the vast majority of cases. Then, when the surviving spouse dies they can use both allowances.

This means a couple, without property, could potentially double their allowance and pass on an estate worth up to £650,000 without needing to trouble the tax office at all.

What is the inheritance tax threshold?

On top of the IHT standard nil rate band of £325,000, there is also a residence nil rate band which allows individuals to pass on up to £175,000-worth of property without paying any tax, so long as it's the family home and being passed on to their children, grandchildren, step-children or foster-children.

This means married couples or civil partners, who pass on their main residence, can leave an inheritance of up to £1m without incurring any IHT.

That extra allowance for homes means that any one person can effectively leave up to £500,000 without paying tax. And married or civil-partnered couples can also combine their property allowances, meaning they can effectively pass on an estate worth up to £1m without any tax becoming due.

However the benefits of the ‘residential nil rate band’ are reduced on the largest estates. For every £2 over £2m, the allowance is reduced by £1. This means that if you have an estate worth more than £2.35m you will not benefit from the additional residence nil rate band allowance.

When do you pay inheritance tax?

HMRC has to receive the payment by the end of the sixth month after a death and interest will be charged if it is not paid in time.

If assets take time to sell, executors may choose to pay in instalments over a 10 year period, but again interest will be charged.

IHT can be paid out of the estate of the person who has died or from the recipient’s account – this will need to be discussed with the executor of the estate.

How to avoid inheritance tax

There are ways for people to maximise the amount they can pass onto their heirs and reduce the amount of IHT they pay. This can include giving money away before you die to reduce the value of your estate as well as specialist investments and life insurance policies.

Because this can be quite complicated, it’s an area where getting some qualified financial advice can be a sensible decision – and the earlier the better because it can take years to pass on wealth in the most tax-efficient way allowed.

A qualified financial adviser, looking at your specific circumstances will be able to help you plan your affairs so that your estate will eventually pass on as smoothly as possible.

Life insurance pay-outs can count towards the value of an estate, so – to hammer home the point - this really is an area where advice helps.

Do you have to pay inheritance tax on gifts?

Giving gifts is one way that some people can pass on wealth before their death, in order to avoid IHT.

For example, everyone is allowed to give away up to £3,000 a year without it being subject to any tax, that’s your annual exemption – so this can be a way to pass on some of your estate in advance without having to worry about tax.

There are a few other exemptions, including for wedding gifts, small presents and gifts from your surplus income which do not reduce your own standard of living.

If you want to make larger gifts, in excess of the gifting allowance rules you can, but whether or not they become liable for IHT depends on how long the person making the gift lives. These are known as potentially exempt transfers and they only become wholly free of IHT seven years after the gift is made.

If you die within three years the full 40% IHT rate applies, but if the donor dies between three and seven years a gradually reducing rate is charged.

There are also strict rules around gifts. For example, if you give away an asset but continue to use it – like a car or a house – then it may still be considered part of your estate.

Meanwhile, gifts to charities are exempt and substantial donations can even cut the rate of tax that has to be paid.

With inheritance tax there’s a lot at stake so it’s important to plan early, discuss the options with your beneficiaries and take some specialist advice on your specific circumstances.

» MORE: How to start thinking about estate planning

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About the author:

Felicity is a personal finance journalist. She regularly writes for The Times, The Mirror and The Independent. She has won five awards for her work, including Household Money Journalist of the year. Read more

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