A guide to inheritance tax policy in the UK

Death and taxes may be the only truly inescapable things in life. That doesn’t mean we don’t resent both – and inheritance tax in particular, or IHT, can cause more resentment than most.

“As a money spinner for the Treasury, inheritance tax pales in comparison with income tax or VAT, yet it is undoubtedly one of the most emotive taxes, generating a disproportionate amount of resentment,” says Mike Hodges, partner at Saffery Champness. “Although only 4 percent of deaths are liable, when people are taxed throughout their life the possibility of being taxed for what they see as a second time, on death, engenders a real sense of injustice.”

 That doesn’t mean you should just ignore inheritance tax altogether. Although most people are aware of it as a concept, many may avoid tackling anything related to death, potentially causing their family to lose out.

To help, we talked to a number of tax, personal finance and legal experts to provide a user’s guide to IHT.

IHT – the basics

On the day of any individual’s death, the total value of everything they own is added up, including the total value of any gifts they have made in the previous seven years of their life, as well as any gifts that they continued to benefit from. The total figure calculated is then reduced by any debts the individual may have. The final balance is subject to inheritance tax.

There are some exceptions: you won’t have to pay inheritance tax at all if you leave everything above the current government threshold to your spouse or civil partner, or to a charity or community sports club. But be aware that if you give your home away to your children, the threshold for paying inheritance tax is raised to £450,000.

You can also pay a reduced rate of 36% on some of your assets, if you give away at least 10% of the net value of your estate to charity.

What will the government want from me?

The first £325,000 of a person’s wealth will be taxed at 0% – the ‘nil rate band rate’ or NRB. The remaining balance will be taxed at 40%.

What about my house?

From April 2017, a family home allowance began to be phased in. This enables your family home to be passed on to children or grandchildren tax-free after death. This allowance will be added to the existing NRB of £325,000, but will be gradually withdrawn from estates worth more than £2 million. Once fully phased in, the additional allowance will add a maximum £175,000 to existing nil rate band by 2020/21, giving couples an aggregate of £1 million joint nil-rate band.

How marriage affects inheritance tax

Being married makes a difference. “The UK has a deliberate policy distinction favouring those in a marriage or civil partnership over unmarried couples,” confirms Saffery Champness’s Hodges. At a practical level, an unmarried couple living together with children shouldn’t assume that there will be an inheritance tax loophole that saves them, just because they live as though they are married, he warns.

“If the couple share a house they will not benefit from the spouse exemption and there will be a 40% inheritance tax hit over the nil rate band of £325,000. The survivor could even be forced to sell the house to pay the tax.”

On the other hand, married couples and couples in a civil partnership with joint assets also get an important benefit. If one partner dies before the other, and your estate is worth less than the £325,000 threshold, the unused amount gets added to the surviving partner’s threshold. “It is important to note that any assets that pass to a spouse or charity are exempt from inheritance tax,” confirms Emma Myers, Partner of Child & Child (part of the Globalaw network). “Any unused NRB can be transferred to the estate of a surviving spouse or civil partner giving, for example, up to £650,000 taxed at 0 percent to the estate of a widow whose spouse left everything to her.”

You can’t take it with you – but giving it away isn’t easy, either

If you give away an asset that’s worth more than the £325,000 threshold and you die within seven years, you’ll have to pay inheritance tax on it. That means transferring your home to your children some time before you die is not the answer.

However, the good news is that when you make regular gifts which are funded by surplus income (i.e. the gifts do not deplete an individual’s capital) are ignored for the purposes of inheritance tax. Each of us has an annual gift allowance of £3,000 that is exempt from inheritance tax, which means that a gift or gifts totaling this value will not need to be taken into account when calculating an estate following death. Other exemptions include varying gift amounts from parents and grandparents to individuals getting married or entering into a civil partnership.

Should I use a Trust?

When an individual is married, gifts can be made to a spouse via a Trust, which means you can safeguard your assets on not just your death, but also on the death of your spouse. This enables you to ensure that your wealth passes onto the desired recipient, such as your children, as opposed to your spouse’s new partner, should they have re-married after your death.

This can make a lot of sense, explains Child & Child’s Myers: for example, an individual can safeguard their assets and ensure that they pass to their children by using a Trust that limits the gift to the spouse and holds it in a trust. “This gives the spouse the right to benefit from the assets but does not give them control of them,” she says. “On the spouse’s death the assets pass to the children and not under their will/intestacy.” A Trust of this type has the added benefit of safeguarding the assets and excluding them from any local authority assessment – for example, with regards to care home funding.

But be aware that since 2006, the Government has changed the rules slightly. Most lifetime trusts created after 22 March 2006, as well as discretionary trusts created before that date, are not taxed on the death of any individual beneficiary – and so are subject to different inheritance tax treatment, known as the ‘relevant property’ inheritance tax regime. And in addition to the 20% entry charge, six percent inheritance tax charge is payable on each tenth anniversary of the Trust’s creation and pro rata inheritance tax ‘exit charge’ on capital distributions between ten year anniversaries. “Pre-March 2006 trusts and Will Trusts where a beneficiary has a right to income are not subject to the relevant property regime. Instead, the assets are treated as belonging to the beneficiary for inheritance tax purposes and are taxed at 40% on death,” warns Simon Malkiel, partner and head of trusts, tax and estate planning at London law firm Howard Kennedy LLP.

What should you do to get started?

It is a really good idea to review your estate regularly. For example, you may decide you have assets that do not produce income that you need to live. Such assets could be gifted during your lifetime rather than waiting and gifting under your Will, reducing your estate for inheritance tax purposes. Don’t do this until you have taken into consideration all other taxes: for example, gifts of property may trigger capital gains tax and gifts into trust may trigger a different IHT charge.

Where there’s a Will…

Another universal bit of advice from the experts is to make a Will – and keep your eye on it so that’s it is always up to date. Without a Will the laws of intestacy govern who inherits – in the case of those who are married with children, your estate may not pass completely to your spouse, but if your Will had been drafted gifting everything to the spouse (either outright or via a Trust), there would have been no inheritance tax to pay.

“It is important to remember that Wills should be reviewed regularly – especially when an individual’s circumstances change,” states Child & Child’s Myers. “If a Will names children or grandchildren, the author will need to update it on the birth of future children or grandchildren, and marriage invalidates any Wills that were not made in contemplation of that marriage. Conversely, divorce does not invalidate the Will but any gifts to the ex-spouse are invalidated. This only occurs on final divorce and so a new Will is needed on separation.”

Other sensible moves

Investing in assets that attract Business Property Relief and/or Agricultural Property Relief could help reduce an individual’s inheritance tax exposure, says Tom Elliott, partner and head of private clients at Crowe UK. “Generally, interests in private trading businesses will qualify for 100% relief, while farming and agricultural assets may attract relief at 50% or 100%.