What is Inheritance Tax?
Updated: Jan 27
Inheritance tax (IHT) was traditionally regarded as a tax only for the very wealthy. However, with a threshold of £325,000 (£650,000 for married couples and civil partners) that will remain frozen until 2021, and the price of houses still relatively high, more and more people could find themselves caught in the net. This could force many people to sell family heirlooms or investment assets to meet tax bills that a little bit of planning could have helped to avoid. This guide is designed to help you through the maze of IHT, outlining who needs to be concerned, explaining how IHT works and introducing some of the allowances that can help to mitigate its effects on your estate. If you would like to discuss any of the points raised, please do not hesitate to contact us.
WHAT IS INHERITANCE TAX?
Inheritance tax is payable when someone transfers ownership of their assets, usually on death. Each individual is entitled to a nil-rate band of £325,000, under which no inheritance tax is payable. Traditionally, few estates exceeded this nil-rate band.
However, the house price boom of recent years has pushed more people into the IHT net. Alongside ISAs, death-in-service benefit, foreign homes or less obvious assets such as paintings or cars, this has boosted the value of an average estate.
The tax rate for all assets over the nil-rate band is 40% so it is possible to build up a large bill quickly. Also, inheritance tax becomes payable relatively soon: it is due six months after the end of the month of death.
This does not give the administrators much time to sell a house or liquidate other assets if that is necessary. With that in mind, if you unexpectedly find your estate now exceeds the taxman’s limits, what can you do?
Although the Government closed many of the loopholes on inheritance tax in the 2006 Budget, a number of exemptions and allowances do remain. Where possible, you should aim to maximise use of these exemptions and allowances if you wish to pass on as much of your hard-earned cash to your heirs as possible.
EXEMPTIONS AND ALLOWANCES
In addition to the £325,000 nil-rate band available on each estate, transfers between husband and wife or between civil partners are free of tax. Since 9 October 2007, such legally recognised partners can also pass over any unused portion of their own nil-rate band so that, in effect, the surviving spouse has up to £650,000. However, this does not apply to cohabiting partners or ‘common-law’ spouses.
Moreover, an additional, transferable nil-rate band is being phased in, which started in April 2017. This enables individuals to pass on their main residence to direct descendants – such as a child or grandchild – without incurring IHT. This allowance is up to £100,000 in 2017/18, rising to £125,000 in 2018/19, £150,000 in 2019/20, and £175,000 in 2020/21. When added to the existing nil-rate band of £325,000, this creates an IHT threshold of £500,000 for estates by 2020/21. Any of this unused allowance can be transferred to the surviving spouse or civil partner, raising the effective IHT threshold to £1 million by 2020/21; moreover, homeowners who opt to downsize will not lose their allowance. However, estates with a net value of over £2 million will suffer a tapered withdrawal of the main residence nil-rate band.
The majority of other exemptions and allowances come about through distributing some of your wealth prior to death. Such assets transferred prior to death are termed ‘potentially exempt transfers’ (PETs) for IHT purposes and they are potentially exempt because, from the day you give them away, the tax due on death is subject to a tapering over seven years, starting at 100% of liability for the first three years, then falling proportionally from 80% over the next four. If you survive the full seven years, the IHT liability on that asset becomes zero.
However, this taper relief only applies to amounts in excess of the nil-rate band. As there is no tax due on the first £325,000, then no taper relief can apply. Therefore, if you give away anything up to £325,000 and die within those seven years, the full amount of the original gift will be added back into your estate and tax will be calculated on the total as if you never gave that amount away.
Having said that, if you do survive seven years, then that amount is considered as having left your estate and you therefore get the chance to benefit from the nil-rate band allowance a second time.
There is an important restriction on PETs called a ‘gift with reservation of benefit’. The principle is that, if you continue to enjoy the benefit of an asset, the transfer is entirely ineffective for inheritance tax purposes. This is in place to stop parents, for example, transferring their homes to their children and continuing to live in them. In order for such a transfer to be potentially exempt, a full market rent would have to be paid to the children after transfer.
IHT ON GIFTS
Gifts of £3,000 or less are allowed annually without being liable for IHT – and, if unused, this allowance can be carried forward for one year. There is also a gift exemption applying to ‘regular gifts out of income’. These gifts can be as much as you like, but they must form part of a ‘pattern of giving’ and HM Revenue & Customs must be satisfied that, after the gift has been made, you are left with sufficient income to maintain your existing standard of living.
You are also allowed gifts on consideration of marriage or civil partnership. The amounts vary according to your relationship to the bride and groom; at the moment, £5,000 is allowed from the parents, £2,500 from the grandparents and £1,000 by anyone else. Gifts to charities also fall outside inheritance tax.
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