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A loved one’s death incurs costs not only for funeral services but also for Inheritance Tax (IHT). The latest survey says that 3.9% of UK death resulted in an IHT charge amounting to £ 5.2 million.
What most people don’t know is that they can actually plan their IHT, which could result in a lesser or possibly no tax at all. By answering the most-asked questions, this article will share with you the fundamental concepts of IHT, most especially how to avoid or reduce IHT.
What is Inheritance Tax?
Inheritance Tax refers to the amount of money that must be paid from passing on the estate of someone who has died. An estate refers to the net worth of the person, which includes the property, savings, pension funds, and other assets minus the debts and liabilities. The payment should be submitted to HM Revenue and Customs (HMRC).
Who Pays Inheritance Tax?
The executor (a person dealing with the estate) is usually the one who manages one’s estate’s Inheritance Tax to HM Revenue and Customs. People who inherit the estate and are eligible for tax exemptions normally pay the tax in other means like income tax from rental, capital gains tax from selling the property or other inherited assets, etc.
What Is the Inheritance Tax Threshold?
The amount of Inheritance Tax to be paid depends on the declared value of the estate. No IHT will be paid on the first £325,000 of the estate’s value (Nil Rate Band/IHT threshold). Anything above £325,000 is subject to a 40% tax.
For example, the declared value of your estate is £900,000. Your tax-free threshold is £325,000. You subtract £900,000 with £325,000, arriving at £575,000, which is the amount to be charged for IHT. Forty per cent (40%) of £575,000 is £230,00.
| Example | ||
|---|---|---|
|
Declared Amount |
£900,000 |
|
|
Tax-Free threshold |
£325,000 |
|
|
Amount Subject to IHT |
£900,000 – £325,000 |
£575,000 |
|
IHT Rate |
£575,000 x 0.40 |
£230,000 |
|
IHT to Pay |
£230,000 |
|
However, there’s a special rule to this; if the estate is passed on death to the direct descendants, there will be an additional Nil-Rate Band of £175,000 (the additional amount applicable between tax years 2020 and 2026), and it will then be increased in line with Consumer Price Index from 2026.
If the estate is passed on to the spouse or civil partner, zero IHT will be imposed provided that the civil partner or spouse is permanently dwelling in the UK. The same rule applies if the estate is passed on to a community amateur sports club or a charity.
A threshold can increase to £500,000 if the estate, specifically a person’s home, will be passed on to the person’s children, provided that the market value of the property is not more than £2,000,000. This extra threshold is known as the Residence Nil Rate Band (RNRB). However, if the estate is worth more than £2,000,000, £1 will be lost for every £2 worth of market value.
A threshold can be up to £1,000,000 for a person who’s married or in a civil partnership since any unused threshold of one partner can be added to his partner’s threshold. The surviving partner can claim the additional threshold on their deceased partner. The extra transferable threshold is known as the Transferable Nil Rate Band (TNRB).
What is the Inheritance Tax Rate?
Forty per cent (40%) is the current maximum inheritance tax rate, which is yet subject to change this 2023. It means that any amount of estate above the given threshold can be charged up to 40%. However, it can be reduced to a 36% rate if the person leaves at least 10% of the estate to a charity.
People who have received gifts from a person who has died may be subject to paying IHT. However, it is only applicable if the person gave away gifts of more than £325,000 and died within 7 years. Gifts refer to anything that has value, such as money, properties, etc.
The table below shows the corresponding IHT rates to the number of years before the person died.
The 7-Year Rule
| No. Of Years Between Gift and Death | Tax Rate |
|---|---|
|
x < 3 |
40% |
|
3 < x < 4 |
32% |
|
4 < x < 5 |
24% |
|
5 < x < 6 |
16% |
|
6 < x < 7 |
8% |
Where x= number of years when the gift was received with respect to the year when the person who gave the gift died.
How Does Inheritance Tax Work?
To understand how inheritance taxes work, take a look at the example below:
John died on 1 January 2021. John left 3 gifts before he died. He gave £280,000 to his older sister 6.2 years before his death. He gave £250,000 to his younger sister 4.5 years before he died. He gave £50,000 to his friend a year before his death. John was only entitled to the £350,000 threshold. In calculating the IHT, anything below £325,000 is tax-free.
John’s older sister has no IHT to pay since the amount of gift she received is within the threshold. After deducting £280,000, there is only a £45,000 threshold left. It means that any further gift that John has given beyond £45,000 will be subject to charge.
Since John’s younger sister received £250,000, which is already beyond the remaining threshold, she should pay for the IHT. The amount subject to tax is £205,000 (£250,000 – £45,000 = £205,000). Considering that the gift was given 4.5 years before John’s death, the corresponding tax rate is 24%.
Thus, the amount to be paid by John’s younger sister is £49,200 (£205,000 x 0.24 = £49,200). John’s friend received a gift a year before John’s death which corresponds to a 40% tax rate. Thus, John’s friend needs to pay £ 20,000 IHT.
See the table below for simplified calculations:
| John’s Older Sister | |
|---|---|
|
Threshold |
£350,000 |
|
Amount of gift received |
£280,000 |
|
IHT to Pay |
0 |
|
Remaining Threshold |
£45,000 |
|
John’s Younger Sister |
|
|
Remaining Threshold |
£45,000 |
|
Amount of gift received |
£250,000 |
|
Amount Subject to Tax |
£205,000 |
|
Tax Rate (4.5 yrs. Before John’s death) |
24% |
|
IHT to Pay |
£49,000 |
|
John’s Friend |
|
|
Amount of gift received |
£50,000 |
|
Remaining Threshold |
0 |
|
Tax Rate (1 yr. before John’s death) |
40% |
|
IHT to Pay |
£50,000 |
| John’s Older Sister | |
|---|---|
|
Threshold |
£350,000 |
|
Amount of gift received |
£280,000 |
|
IHT to Pay |
0 |
|
Remaining Threshold |
£45,000 |
| John’s Younger Sister | |
|---|---|
|
Remaining Threshold |
£45,000 |
|
Amount of gift received |
£250,000 |
|
Amount Subject to Tax |
£205,000 |
|
Tax Rate (4.5 yrs. Before John’s death) |
24% |
|
IHT to Pay |
£49,000 |
| John’s Friend | |
|---|---|
|
Amount of gift received |
£50,000 |
|
Remaining Threshold |
0 |
|
Tax Rate (1 yr. before John’s death) |
40% |
|
IHT to Pay |
£50,000 |
How to Avoid Inheritance Tax?
There are exemptions of IHT, such as the following:
- There is no inheritance tax for small gifts (anniversaries, birthdays, etc.) that a person makes out of his normal income.
- There is no IHT on gifts between spouses or civil partners, provided that their partners are permanently dwelling in the UK (domiciled or considered as domiciled).
- A person can give away £3,000 worth of gifts each tax year without being subject to IHT. This is known as the “annual exemption”. If a person can’t use the “annual exemption” in the current assessment year, it can still be used for the next assessment year.
- A person can give away wedding or civil ceremony gifts of up to £1,000 per person, £2,500 for a grandchild or great-grandchild, and £5,000 for a child.
- There is no IHT for payments for the purpose of helping another person’s living costs as well as for gifts to political parties and charities.
- Moreover, there is also no IHT for gifts of up to £250 per person, provided that no other exemption was applied to the same person.
When Do You Pay Inheritance Tax?
Inheritance Tax should be paid 6 months after the death of the person. Interest will be charged if not paid on the expected date.
What Other Taxes Do My Heirs Have to Pay on Their Inheritance?
Usually, heirs don’t pay other taxes upon receiving their inheritance, but they do when they earn from it such as by renting or disposing it out. After fulfilling their inheritance tax liabilities and finally taking hold of the estate, heirs may pay other taxes, such as the following:
• Income Tax
Heirs will pay income tax if the asset continues to generate income, such as when it earns dividends on shares or rental profits. The tax-free threshold is set at £12,570. Anything above that personal allowance, they will pay different rates according to their taxable income figure.
• Capital Gains Tax
Once they dispose of their assets, they will also be liable to CGT. “Disposal” doesn’t mean just selling but also when they swap it for other assets, or they receive compensation if they’re lost or broken. CGT tax-free threshold is £6,000. The rest of the taxable amount will be subject to CGT.
Debunking the Common Misconceptions about Inheritance Tax
The inheritance tax remains shrouded with mystery, evoking some myths that some people still surprisingly believe. Let’s take a look at the most common misconceptions about IHT and the truth behind them:
• Giving Away Assets Before You Die Helps You Avoid IHT
Many people believe that gifting away their money or assets before they die will help them avoid inheritance tax. The truth is you can only give up to £3,000 each year free from tax and any amount above that, anything you gave away seven years before your death is still subject to IHT.
• Spouse Receives Everything Upon Death and That There Will Be no Tax to Pay
This is not true at all. Whoever receives your estate depends on your will. If you have no will, the law of intestacy in England and Wales usually decides the estate goes to a surviving civil partner or spouse and children. The inheritance tax exemption only applies to those in married or civil relationships.
• Children Receives IHT-Free Estate
The 7-year rule applies again, so this is one of the many misconceptions too. The property you give is considered a gift, so it’s subject to gift tax. The best way to avoid IHT is to move out and not earn anything from it. You can also use the Gift with Reservation of Benefit (GROP) so it doesn’t fall under the 7-year rule, which allows you to give your estate but still live in it but pay the child rent at the market rate.
• Any Gift Above £3k is Subject to IHT
Truth is, this only applies upon the death of the giver. Anything below that amount is not subject to tax even if you died within seven years.
• No IHT to Pay When You Move Abroad
This is another misconception; you can’t run away from your inheritance tax liabilities even if you’ve moved abroad, which will depend on your UK domicile status—when you last lived in the UK and your permanent home at the time of your death.
How to Pay Inheritance Tax
A payment reference number is needed to begin the process of payment. It is advised to get the reference number from HMRC at least three weeks before making a payment. There is a traditional process set by the UK government on how to pay IHT, but you can also seek help from tax experts to smooth out the process.
How Legend Financial Can Help
Inheritance tax is quite complex at first, but if you only know how to manage and are fully aware of the tips and tricks, you can save more than you could imagine. Legend Financial is here to help curb your IHT liabilities as much as possible.
If you want to know more about IHT, send us a message or schedule a meeting with us. Our team would be more than happy to help you on this matter. If you have questions about anything in this article, kindly give a comment below, and we’ll reply to your inquiry as soon as possible.
References
What reliefs and exemptions are there from inheritance tax? (Updated 10 June 2022). Retrieved from Low Incomes Tax Reform Group: https://www.litrg.org.uk/tax-guides/bereavement/what-reliefs-and-exemptions-are-there-inheritance-tax
Inheritance Tax thresholds and interest rates. (Updated 8 November 2022). Retrieved from Gov.UK: https://www.gov.uk/government/publications/rates-and-allowances-inheritance-tax-thresholds-and-interest-rates/inheritance-tax-thresholds-and-interest-rates
Inheritance Tax statistics: commentary. (Updated 28 July 2022). Retrieved from Gov.UK: https://www.gov.uk/government/statistics/inheritance-tax-statistics-commentary/inheritance-tax-statistics-commentary
3 responses
Do you have to pay the tax before fund are released. Also before the house is sold.
This article was very informative, and the examples made understanding inheritance tax very easy. I didn’t know anything about inheritance tax beforehand, but after reading this article, I feel confident enough to even guide someone else on inheritance tax!