We help you get to grips with a much-reviled tax and break down the ins and outs of estate planning.
Inheritance tax (IHT) is widely disliked as a double levy on assets built up from taxed income over a lifetime of work.
In fact only 4-5% of UK estates currently pay it. However, as the baby boomer generation dies, leaving homes that have soared in value, many more families will be caught. IHT receipts could rise by a third, from £5.2 billion in 2017 to £6.9 billion in 2024, according to the Office of Budget Responsibility.
IHT is currently payable at the rate of 40%, and the first thing to know when calculating your liability is that it is paid only if the value of your estate exceeds the nil rate band (NRB), which is £325,000, fixed until 2021. So if your estate is worth £525,000 and your IHT threshold is £325,000, the tax will be £80,000, or 40% of £200,000 (£525,000 - £325,000).
Inheritance tax liabilities set to rise further
Spouses and civil partners’ transfers
Spouses and civil partners can leave any value of assets above the NRB to the survivor on death and avoid any liability.
However, if your partner is non-domiciled in the UK, the assets you can give them without incurring a liability are capped at a special spouse’s exemption of £325,000, on top of the usual £325,000 NRB, or £650,000 in total. Non-UK domiciled spouses or civil partners can elect to be treated as UK-domiciled for IHT purposes and take advantage of transfers with full exemption; but on their death their worldwide assets are subject to UK inheritance tax, which might be detrimental if those assets are sizeable.
Any unused NRB when the first partner dies can be rolled over to the survivor, boosting their available NRB to a maximum £650,000. This is known as the transferable nil rate band (TRNRB).
The residence nil rate band (RNRB), or home allowance, is an additional threshold that reduces the IHT payable on your estate, and is designed to make it easier for families to pass on the family home. It is £150,000 in 2019/20 (£175,000 in 2020/21) and applies if you’re giving away your home to your direct descendants, defined as children or grandchildren including adopted, foster and step-children. The RNRB is added to the NRB; for instance, in 2019/20 your total IHT threshold would be £475,000 (£325,000 + £150,000), and in 2010/21 it would be £500,000 (£325,000 + £175,000). However, the RNRB allowed is limited to the value of the home bequeathed.
Any RNRB that’s not used when someone dies can be transferred to their spouse or civil partner’s estate on their death. This is so even if the first death in a couple occurred before 6 April 2017, when RNRB was introduced - provided the surviving partner leaves a home to their descendants. The home that the surviving partner bequeaths doesn’t have to be a home the couple lived in together, so long as the deceased lived in it at some stage.
If the surviving partner sold or gave away their home after 7 July 2015 and they leave other assets to their direct descendants, the RNRB may still be available under downsizing rules, provided the former home would have qualified had they kept it until they died. The aim of this concession is to prevent elderly couples feeling forced to retain the family home purely to save tax by way of the top-up RNRB, so a person who moves into care is not penalised.
The RNRB is tapered if the estate’s value exceeds £2 million, falling by £1 for each £2 above the threshold. Based on RNRB
of £175,000 in 2020/21, there will be no RNRB if the estate exceeds £2.35 million, or £2.7 million including the full brought-forward spouse allowance.
Gifts and exemptions
During your life you can give away £3,000 a year without it being added to your estate for IHT purposes, and if part of
this annual exemption is not used in a tax year, it can be carried forward to the next year. You can also give gifts of up to £250 to as many other individuals as you wish, free of IHT. Certain wedding gifts are exempt, including up to £5,000 from each parent to the happy couple, and £2,500 from each grandparent.
You can make as many gifts as you like with no immediate exemption, but as long as you live a further seven years your estate won’t have to pay IHT on them when you die. When the gift is first made, it is called a potentially exempt transfer (PET). If you die within the seven-year period, IHT is charged at 40% on gifts given within three years of death, and a sliding-scale ‘taper relief’ applies for gifts given between three and seven years before death (see table below). Donations to charities are also exempt.
|Years between gift and death||Tax paid|
|Less than 3||40%|
|3 to 4||32%|
|4 to 5||24%|
|5 to 6||16%|
|6 to 7||8%|
|7 or more||0%|
All assets such as bank deposits, property, jewellery, cars, investments and insurance policies should be included in any estimation of your estate, plus any gifts given in the last seven years. You should also include any gifts you have continued to benefit from (known as ‘gifts with reservations of benefit’), for example if you have given away your house but still live in it.
Any debts such as household bills, mortgages and credit card debts should be deducted from the estate’s value, and ultimately that could include funeral expenses.
Tax relief at either 50% or 100% is available on some business assets, such as farms, so long as the assets were owned for two years before death. A special relief for growing timber defers the tax until the timber has been sold, while commercial woodlands owned for at least five years before death may be eligible for 100% business relief.
Setting up a trust
You can also reduce your IHT liability by setting up a trust. Generally speaking, if you, your partner and your children under 18 years old are no longer able to benefit from the assets you put in trust, those assets are no longer considered part of your estate for IHT purposes. For example, you could set up a trust to help support your grandchildren’s university education, or to provide care for a disabled family member.
However, if you want your partner or children to benefit from the trust, then the most commonly used trust for IHT planning is a discretionary trust. A 20% IHT charge is made on the value of assets transferred into the trust (over the nil rate band), and there’s a tax charge on the assets every 10 years afterwards and an exit charge when assets are removed from the trust. If you die within seven years of making the transfer, the sum will be brought into the IHT calculation.
Under these trusts, the trustees have the power to change the beneficiaries depending on changing circumstances. They are useful, for example, for safeguarding assets from a beneficiary who is going through a divorce settlement, because the beneficiary is not entitled outright to the trust fund and so assets can’t be treated as belonging to him or her.
If you have a concrete goal for your trust, you might instead prefer to set up a bare trust, which gives the named beneficiaries the absolute right to the capital. This means that any income arising is treated as the beneficiaries’, as they are absolutely entitled to that income. A bare trust could be used, for example, to delay giving funds to a child until they are of responsible age. Assets placed in these trusts are treated as PETs.
Reform or abolition could be coming down the line
Suddenly politicians from all political parties have caught on to the concept that IHT is hugely unpopular and primarily penalises the middle classes, because the rich use sophisticated measures to circumvent it. It’s been called the only “optional tax”, as you pay it if you do not take precautions not to – but those precautions often require being so wealthy that you can give your money away.
The Conservative government has not yet played its hand, but Chancellor Sajid Javid is said to be in favour of axing it altogether. Alternatively, the Tories might implement the recommendations of the Office for Tax Simplification, which included replacing the seven-year taper with a five-year cut-off and simplifying the outdated annual allowances.
The Labour Party has pledged to scrap the current IHT system altogether and instead cap the amount any one individual can receive in inheritance in their life- time at £125,000, which it sees as a move to share out the unearned wind- falls arising out of the housing boom. This would mean a couple with two children could leave them just £250,000 tax-free. Any gifts received above this would be taxed at income tax rates.