Understanding Inheritance Tax

Inheritance tax is not widely understood, perhaps not surprisingly because few of us like to think about what will happen when we die. However, with a little knowledge and advance planning, you can make a significant impact on how much of your estate you can leave to your loved ones.

Sky high house prices in many areas of the country, and a tax threshold that has been fixed for more than 10 years, mean that more people than ever are finding themselves and their loved ones facing an inheritance tax bill. In fact, recent statistics from HMRC show that the government raised over £5.4bn from inheritance tax in the 2018/19 tax year alone, with average liable estates paying £179,000 in tax. HMRC received a total of £5.2bn from inheritance tax in 2019/20 tax year. Although this is a slight decrease on the preceding tax year, recent years have seen a growing number of estates finding themselves caught with a bill to pay.

What is inheritance tax?

Inheritance tax is charged on the value of your assets above a certain threshold when you die. It can also apply to some specific gifts and transfers made during your lifetime.

The current inheritance tax threshold, called the ‘nil-rate band’, has been set at £325,000 since April 2009 and any assets over and above this amount are subject to tax of 40%. The Chancellor confirmed in the March 2021 Budget that the threshold would continue to be frozen at this level until 2026.

To work out the value of your estate you should work out the value of all the assets you own. These include:

  •  Your house and any other properties you own
  •  Any savings or investments (some types of pensions are excluded from your estate, but other investments, including ISAs, are taxable)
  • Any other assets
  • The value of any life insurance policies in your name.

Then subtract any outstanding debts you have, such as mortgages, credit cards and loans. You can also deduct charitable donations you’re planning to leave in your will along with reasonable costs for your funeral.

Example – Penny has savings of £50,000 and owns property worth £375,000 when she dies. Her estate is therefore worth £425,000. After subtracting her nil rate band of £325,000, Penny’s taxable estate is reduced to £100,000. Her estate will then need to pay tax of 40% on this, resulting in a total tax bill of £40,000.

Marriage and inheritance tax

If you’re married, or have a civil partner, you can leave your entire estate to your spouse or partner free of inheritance tax. The good news is that transfers between spouses like this do not use up any of your nil rate band and in fact, your unused nil rate band can be transferred to your spouse or civil partner. For example, if your spouse left everything to you before they died, you’d typically have a larger estate when you die, but you could potentially also have a nil-rate band of £650,000 applied to the value of your estate – your own £325,000 nil rate band, combined with the transfer of your partners £325,000 nil rate band.

Example – Continuing the example above, if Penny chooses to leave her entire estate to her husband Jack, there is no inheritance tax due at the point of Penny’s death. Jack now not only owns his half of the property, but also the half he inherited from Penny – totalling £750,000. In addition to the £50,000 of savings he inherits from Penny, he has his own savings of £30,000 making a total savings pot of £80,000.

When Jack dies, his estate is worth £830,000 (£750,000 + £80,000). Because Penny did not use up any of her own nil rate band, Jack can transfer it to his own estate giving him a combined nil rate band of £650,000. Subtracting this from Jack’s total estate provides a taxable estate of £180,000 which is to be taxed at 40%. This leaves Jack’s estate with a total tax bill of £72,000. 

The main-residence allowance explained

A recent addition to the already complicated nature of inheritance tax is the main residence allowance. This allowance applies in addition to the existing nil rate band, but only where the person who has died is transferring a property that was once their home, to their direct descendants (i.e. children or grandchildren). The residence nil-rate band is currently £175,000, having increased to this limit in April 2020.

You can transfer this extra allowance to your surviving spouse when you die if you haven’t already used it. This means that in the current 2020-21 tax year, a married couple could potentially leave their children a combined estate of up to £1m, without facing an inheritance tax bill.

There are a number of situations where the main-residence allowance will not be of benefit. Specifically it won’t help you if you don’t own a property or if you sold your property before 8 July 2015 because for example, you moved into residential care or are living with your children. It also won’t help if you don’t have any direct descendants, so for example, if you wish to leave your home to a niece or nephew.. At the top end of the spectrum, those with large estates will see the main-residence band reduce by £1 for every £2 by which the estate exceeds £2 million. At the other end of the scale, those with a property worth less than £175,000 per person, or £350,000 per couple, will only benefit to the value of their house.

How can I reduce the amount of inheritance tax due?

There are a number of simple steps you can take to reduce the amount of inheritance tax that may be due on your estate. We have listed some of the most straightforward options below but bear in mind that these may not be suitable for you, so you should seek professional financial advice if you’re looking for specific recommendations based on your individual circumstances You can find a local financial advisor on VouchedFor or Unbiased, or for more information, check out our guide on How to find the right financial advisor for you.

The importance of writing a will

The most important thing you can do in your lifetime to ease the pain for your friends and family when you die is to write a will. This should detail what you want to happen to your assets and personal possessions after you die. It can also specify critical things such as who you would want to be the legal guardians of your children, or grandchildren if you have parental responsibility for them. It is of critical importance for a number of reasons, but could also have a significant bearing on how much inheritance tax your estate has to pay. For more information, please see our guides on The importance of writing a will and guidance on How to write a will.

Have you taken any steps to reduce potential inheritance tax bills? If so, we’d be interested in hearing from  you. You can join the money conversation on the Rest Less Community forum, or leave a comment below.

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