A Complete Guide to Inheritance Tax

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By Crispin Bateman

Updated on Tuesday 4 February 2020

Estate planning and inheritance tax

We generally tend to assume that all of our estate will be passed on to our dependants automatically when we pass away, but that’s not always the case. A large proportion of the assets that you leave to your loved ones will unfortunately be subject to inheritance tax, also known as death tax.

In this guide, we explain what the 2020 UK threshold for inheritance tax is, how to increase your threshold, how to calculate your inheritance tax, how you can avoid paying it legally, and just about everything else you need to know about the dreaded IHT!

What does inheritance tax mean?

Calculating inheritance tax

Life insurance and IHT rules in the UK

What is inheritance tax?

Inheritance Tax (IHT) is a tax owed to the government upon death, which  is placed on the deceased person’s estate (including all assets such as property, money, possessions, etc). It can be quite a sizable sum, but there are various allowances and thresholds which make it a lot more bearable.

The most important of these is the inheritance tax nil rate band (NRB) – which lists the threshold under which you pay no tax. The inheritance tax threshold for 2020 (NRB) is currently set at £325,000, and will remain so until a revision in 2021. If the estate is worth £325,000 or below,it will not be subject to any inheritance tax.

You also pay no inheritance tax when leaving everything to your spouse or civil partner or, additionally, if the entire estate is left to an exempt beneficiary – for example, a charity.

What is included in an estate when someone dies?

An estate is the total amount of assets a person has upon their death – it can include:

  • All current cash and savings
  • Businesses
  • Any company stock
  • The value of any owned property
  • The value of all other assets (for example, cars, jewellery, art, collections)
  • Life insurance pay-outs not in trust

Then deduct any debts or liabilities which must be paid:

  • Mortgage
  • Loans
  • Credit card debt
  • Other debt
  • Funeral expenses

The inheritance tax seven-year rule and gifts with reservations of benefit

The seven-year rule means that, in order to prevent people avoiding IHT by giving away assets in their twilight years, they must also include in estate calculations anything which has been given away in the seven years prior to death. For example, a house that has been given (or sold for less than market value) to a family member or friend still counts when calculating the final estate value, and could therefore be subject to inheritance tax.

A gift with reservation of benefit (GWROB) is an asset which has been given away (even prior to the seven year threshold) yet was still of benefit to the deceased up to their death. This might include a car that was given away, yet still driven by the deceased, or a house which was passed on to another but still lived in for less than market value of rent.

Despite perhaps seeming an inconvenience, these rules are in place to avoid fraud and the wrongful evasion of inheritance tax.

But there are, thankfully, legal ways to avoid inheritance tax in the UK.

When determining the value of an estate, be sure to keep detailed records of its calculation and ensure that everything is reported accurately.

How to calculate inheritance tax

If the estate is valued at £325,000 or less (within the nil-rate band), your beneficiaries do not have to pay death tax. This UK inheritance tax threshold covers a large majority of situations nationally.

If the estate is passed on to a spouse or civil partner, there is no need to pay inheritance tax, and the same goes if the estate is passed on to a charity or other exempt beneficiary.

The Residence Nil Rate Band (RNRB)

Leaving your home to your children instead of your partner could be one way to avoid inheritance tax on property by raising the current inheritance tax threshold. As an additional threshold, the RNRB is an extra amount (set at £175,000 in 2020 to 2021) which is added on to the NRB if the home, or a share of it, is passed to children or grandchildren (which includes step-children, adopted children and foster children).

This additional allowance is only relevant to the passing on of a home and doesn’t come into effect for other aspects of the estate.

The RNRB rises in accordance with the Consumer Price Index (CPI). In 2018, it was £125,000, while it rose to £150,000 in the 2019/20 tax year, and now, in 2020, it has increased again to £175,000. It will continue to increase in line with the CPI from 2021 onwards.

With the NRB (£325,000) and RNRB (£175,000) combined, the current (2020) tax-free threshold for those inheriting a home from their parents or grandparents is £500,000.

What percentage is inheritance tax in the UK?

Inheritance tax is charged at 40% once the thresholds have been reached and accounted for. So, any of your estate over the £325,000 threshold will be charged 40% inheritance tax.

Examples (correct as of 2020):

An estate worth £500,000 passed to a spread of family members will have a taxable amount of £175,000 (£500,000 minus the NRB of £325,000). Your estate will therefore be taxed 40% of £175,000, which is £70,000.

An estate worth £350,000 including the family home, passed on to the children of the deceased will have a taxable amount of £0 (because £350,000 comes under the NRB + RNRB threshold of £500,000).

An estate worth £1,200,000 passed in full to the widow of the deceased will have a taxable amount of £0 because spouses are exempt from inheritance tax.

An estate worth £1,000,000 including the family home worth £500,000 passed to the grandchildren of the deceased will have a total taxable amount of £500,000 (£1,000,000 minus the combined NRB/RNRB threshold of £500,000). The estate will therefore be deducted 40% of £500,000, which totals £200,000.

Who pays the inheritance tax to HMRC?

The executor of the will is in charge of arranging to pay the IHT. In situations where there is no will, the administrator of the estate will do this. Contrary to popular belief, the beneficiaries (the people who inherit your assets) normally do not have to deal with tax issues.

When do you pay inheritance tax?

Normally, IHT should be paid within the first six months after the death. If the tax is not paid after this time, HMRC will begin to add interest to the remaining total.

It is possible to arrange an instalment plan with HMRC (for example, to avoid selling the home immediately to pay for taxes), but be aware that this will incur interest.

Sometimes it can take a long period to properly calculate the value of the estate. If this is the case and it is expected that IHT will be due, it is a good idea to have the executor pay off some of the tax before the six-month period to avoid interest. Money paid out of other accounts not held as part of the estate can be reclaimed from the estate once the value is fully calculated.

HMRC will always refund any overpayments.

Distributing inheritance to beneficiaries

The executor of the will does not usually distribute the remains of the estate to the beneficiaries until IHT has been paid in-full or any arrangement for a longer-term payment plan has been put in place.

Life insurance and inheritance tax

Life insurance policies can play a big part in IHT, as they can be set up to make a one-off payment, placed in trust, which covers the costs of inheritance tax.

It is important that any life insurance policies designed with this in mind are placed in trust rather than being paid directly into the estate, otherwise they become part of the taxable estate value themselves!

Using life insurance to pay IHT is an advised strategy for anyone who expects to leave a sizable estate for their family.

Read more: Putting Life Insurance in Trust

What other taxes do you have to pay on inheritance?

If anything inherited provides a regular income (for example, rent from a property) then it will be subject to income tax in the future.

Selling anything on and making a profit in the process could incur either income tax or, if the profit is substantial, capital gains tax.

For more advice on inheritance tax, or for a more in-depth look at some of the other options available with life insurance policies to cover IHT for your family, take a look at our library of articles here at CUKQ.

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