The basic definition of Inheritance Tax (IHT) is that it is a tax placed on the estate of someone who has died. This type of taxation can sometimes be a reason for confusion and concern for families. 

People worry about a large portion of their loved one’s assets being taken up by tax, but the truth is that a relatively small percentage of estates actually end up paying it. In the UK, Inheritance Tax (IHT) is charged at a standard rate of 40% on the value of an estate that exceeds £325,000 threshold.

This article will provide you with a comprehensive understanding how IHT works, what reliefs and/or exemptions that are available, along with other key information that you will find useful when it comes to paying Inheritance Tax. Keep reading to know more.

A brief intro to Inheritance Tax

As described above, essentially IHT is the tax payable to the government of UK (HMRC) once the owner of the estate is deceased. This tax comes into play only if the estate value is more than £325,000. And then only the amount that exceeds £325,000 is taxed. In this example, if the total value of the estate is £475,000, then you will be taxed only for the additional difference which is £150,000 (I.e:  £475,000 – £325,000 = £150,000). 

You may also wonder why the term ‘estate’ is used when referring to IHT, this is because everything that was owned by the deceased person is included under this term, not just house and property. For instance his/her personal possessions, savings, liquid cash, vehicles, etc. The term ‘estate’ refers to all of these things. 

Who has to pay inheritance tax and who doesn’t?

When the value of the estate exceeds the above said threshold, IHT is payable using the funds generated from the estate. And usually the person named as the ‘executor’ will have to carry out the task of settling the tax. Payments of IHT are directly payable to the HMRC. If there are beneficiaries of the estate named in the will, they will usually not be required to pay inheritance tax. However, if the property they inherit generates an income of sorts, such as a rental, then they will have to pay a tax related to that business based on its income.

In some instances, the owner of the estate who passed away may have obtained a full life term insurance policy. If this is the case, and if there is IHT to be paid, it can be done using the money that is available from the insurance policy. It must be noted that all the insurance premiums should have been paid without arreas if this money is to be used for IHT settlement. 

Understanding the nil-rate band and residence nil-rate band

Probably considered as the most important component of IHT is the tax-free allowance, known as the Nil-Rate Band (NRB). Currently, the NRB is £325,000. What this means is as described briefly above, the first £325,000 of the deceased person’s estate is exempt from IHT. 

In addition to the standard NRB, there is another allowance called the Residence Nil-Rate Band (RNRB). This was introduced to help families pass on their home to direct descendants more easily. The RNRB is currently £175,000. However to qualify for this tax allowance, you must fulfill the following.

• Own a home.
• Leave the estate to a direct descendant in your will. This includes your children, adopted children, stepchildren, and grandchildren. However you may want to note that it does not apply to nieces, nephews, or siblings.
• Your estate must be valued at less than £2 million. For estates valued over this amount, the RNRB is tapered down. Estates worth over £2 million have a different calculation method that HMRC utilises for tax valuation. 

How does IHT affect spouses and civil partners?

One of the most significant IHT exemptions is for married couples and civil partners. When the first partner dies, they can leave their entire estate to their surviving spouse or civil partner completely IHT free.

Any unused portion of the deceased partner’s Nil-Rate Band (NRB) and Residence Nil-Rate Band (RNRB) can be transferred to the survivor. This means the surviving partner can have a IHT free allowance of up to £1 million.

Exemptions and reliefs

Going beyond the NRB and RNRB, there are other exemptions that can reduce or even eliminate IHT.

• Spousal exemption – As mentioned above, any assets left to a spouse or civil partner are completely exempt from IHT.
• Gifts to charity – Any assets that you leave to a registered charity are also exempt from IHT. If you leave at least 10% of your estate to charity, the IHT rate on the rest of your taxable estate is reduced from 40% to 36%. But tax may apply to the remaining estate according to its value.
• Annual exemption – Annually, you can give away up to £3,000 without it being counted toward the value of your estate for IHT purposes. If you don’t use this allowance within that first year, you can carry it forward to the next, but this applies only for one year.
• Small gifts – You can give as many gifts of up to £250 per person per tax year as you want, as long as the recipient has not received any other gifts from your annual exemption.
• Wedding gifts – A great way to reduce the size of your estate and wedding gifts up to £5,000 is tax free.

Potentially Exempt Transfers (PETs)

A well-known and important rule to be aware of in the UK when it comes to IHT. Any gift you make to an individual during your lifetime is considered a Potentially Exempt Transfer (PET). This gift is completely IHT-free only if you survive for seven years after making it.

If you die within the seven-year period, the gift may be subject to IHT. The amount of tax due however tapers down on a sliding scale after three years, which is known as taper relief. This means the tax rate decreases the longer you live after the gifting.

Conclusion

Inheritance Tax can seem like a straightforward affair, but this is deceptive and needs careful planning and an understanding of the rules. Families should and can take steps to ensure their assets are passed on as they are intended. Speaking with a financial advisor such as a professional accountant at BVS Accounting is often a great way to get a clear picture of your specific situation and create a plan that works for you and your loved ones.