Estate tax planning for you and your family
Death is a difficult conversation for families to have but nonetheless a vital one. Ampla Finance, a legal finance company, commissioned a YouGov survey with 2,165 UK adults which found that 44% haven’t tackled the conversation of tax and financial planning with their loved ones following their death.
The study highlighted a widespread lack of awareness around family finances and the probate process with only 11% of respondents having enough understanding of the probate process.
The survey also revealed that inheritance funds were a “key financial pillar” rather than a windfall for 57% of the respondents, which helped bolster essential savings, pay bills, clear personal debt or help fund a house deposit.
More worryingly, only 14% of respondents knew that inheritance tax must be paid within six months of the date of death.
The UK probate system is notoriously complicated and slow-moving, and the lack of knowledge around how it works only exacerbates the issue. Lack of knowledge and delays can badly impact a family’s financial and tax planning so we should endeavour to have frank conversations on family finances now, even though we know it can be difficult.
Back to basics - what is inheritance tax (IHT)?
Inheritance tax is a tax on the 'estate' of someone who's passed away.
How much you pay depends on the value of the deceased's estate – which is valued based on assets (cash in the bank, investments, property or business, vehicles, payouts from life insurance policies), minus any debts.
Importantly, there is normally no IHT to pay if:
The value of your estate is below £325,000.
Or you leave everything over £325,000 to your spouse, civil partner, a charity or a community amateur sports club.
If neither of the above applies, your estate will be taxed at 40% on anything above the £325,000 threshold when you die (or 36% if you leave at least 10% of the net value to a charity in your will).
Why do we have to pay inheritance tax (IHT)?
The politics of inheritance tax are controversial. The idea is that without it you perpetuate inherited wealth, so the children of the rich stay rich. Inheritance tax redistributes income so some of the money goes to the state to be distributed for the benefit of all.
The argument against it is that when money's earned, tax is paid at the time, so to pay tax on it again isn't fair.
After years of rocketing property prices, many more people have been caught by the inheritance tax threshold, raising it higher up the agenda. Yet whatever your views politically, inheritance tax is a financial fact, so it makes sense to know how it will affect you, and whether you can soften the blow.
What happens if I inherit my parents' home?
In the current tax year 2021/22, no inheritance tax is due on the first £325,000 of an estate, with 40% normally being charged on any amount above that. However, what is charged will be less if you leave behind your home to your direct descendants, eg, children or grandchildren. This is because you will then have two tax-free allowances:
£325,000 - this is the basic IHT allowance, which still applies.
£175,000 - since 2015 you've also been able to take advantage of something called the 'residence nil rate band', commonly known as the 'main residence' band. This is an additional allowance you'll receive ON TOP of the existing £325,000 inheritance tax allowance if you pass on a main residence to your children or grandchildren.
This means inheritance tax might not be due on the first £500,000 of your estate (£325,000 + £175,000), depending on who you leave your home to. However:
The £175,000 main residence allowance only applies if your estate is worth less than £2 million.
On estates worth £2 million or more, the main residence allowance will decrease by £1 for every £2 above £2 million that the deceased's estate is worth.
Working example
Let's say your estate is worth £525,000 and you decide to leave your home to your children. This means no inheritance tax will be charged on the first £500,000 (£325,000 basic allowance + £175,000 main residence allowance). There'll be a 40% charge on the remaining £25,000, giving a total of £10,000 if inheritance tax to pay when you die by your children (presuming you're not leaving anything to charity).
If you weren't leaving your home to your direct descendants, you'd pay nothing on the first £325,000 of your estate, and 40% on the remaining £200,000, meaning a total of £80,000 to pay in inheritance tax.
Are the IHT rules different if I'm married?
There are special rules for married couples or those in civil partnerships:
When you die, assets left to your spouse or registered civil partner, provided they're living in the UK, are exempt from inheritance tax.
On top of this, your partner's inheritance tax allowance rises by the percentage of your allowance that you didn't use, meaning together a couple can currently leave £1m tax-free (2 x £325,000 tax-free allowance + 2 x £175,000 main residence allowance).
Working example
Mr and Mrs Smith have assets worth £1m between them. Mr Smith dies first in June 2021 leaving everything to Mrs Smith so his £325,000 tax-free allowance is passed on, as well as his £175,000 'main residence allowance' tax relief. In total, this means Mrs Smith may have up to a £1m tax-free allowance: her allowance, plus her inherited allowance from her deceased husband.
Gifting in your lifetime to reduce your IHT
While you’re alive, you have a £3,000 ‘gift allowance’ a year known as your annual exemption.
This means you can give away assets or cash up to a total of £3,000 in a tax year without it being added to the value of your estate for Inheritance Tax (IHT) purposes at the time of your death.
Any part of the annual exemption which is not used in the tax year can be carried forward to the following tax year. It can only be used in the following tax year and can’t be carried over any further.
Gifts that are worth less than £250
You can give as many gifts of up to £250 to as many individuals as you want who have not already received a gift from you in a given tax year.
Wedding gifts
If the wedding gift is to be effective for inheritance tax purposes, it has to be made before, not after, the wedding and the wedding has to happen and has to be:
given to a child and is worth £5,000 or less,
given to a grandchild or great-grandchild and is worth £2,500 or less, or
given to another relative or friend and is worth £1,000 or less.
Gifts to help with living costs
Gifts to help pay the living costs of an ex-spouse, an elderly dependent or a child under 18 or in full-time education could be exempt. Speak to an advisor to learn more.
Gifts from your surplus income
If you have enough income to maintain your usual standard of living, you can make gifts from your surplus income. For example, regularly paying into your child’s savings account, or paying a life insurance premium for your spouse or civil partner.
To make use of this exemption, it’s very important that you keep very good records of these gifts otherwise, Inheritance Tax might be due on these gifts when you die.
Grandparents can also use it to pay for things like their grandchildren’s school fees.
Charitable gifts
If you give a gift to a charity, museum, university or community amateur sports club, this is exempt from tax.
But be careful of the ‘potentially exempt transfer’ (PET) rule
A Potentially Exempt Transfer (PET) enables an individual to make gifts of unlimited value which will become exempt from Inheritance Tax (IHT) if the individual survives for a period of seven years.
If you don’t survive the gift by seven years, the PET is added to the value of your estate to be charged IHT.
If you die within seven year, the IHT due will reduce or taper, so for example, if you die within three years of the gift, the IHT due on the gift will be 32%.
Working example
For example, if a gift of £400,000 is given:
The gift will initially use up the available NRB of £325,000 (with the oldest gifts are attributed first).
The remaining £75,000 on death is then subject to IHT (in addition to IHT on the remaining estate).
If the remaining £75,000 was given over three years before the death, taper relief may apply.
For example, if the whole gift was made between three and four years before the death, the tax charge on the £75,000 would be 32%.
So IHT due on the PET would be £24,000.
Be careful:
Gifts where you still have an interest in it, no matter when you’ve given gifted it, don’t qualify as a PET.
For example, if you continue to live rent free in the house you gave your child more than 10 years ago, the house would still be considered part of your estate and therefore subject to IHT. This is known as a gift with a reservation of benefit.
What about Trusts?
Trusts are hugely complex from a tax perspective and there are different tax rules depending on the trust you set up. If you want to set up a discretionary trust for example for your grandchild with £100,000 cash this will be a classified as a ‘chargeable life time transfer’. The inheritance tax nil rate band is still available of £325,000 so only if you have already used up your nil rate band (NRB) in the last 7 years would inheritance tax would be payable. The IHT rate would be 20% at the time of setting up the trust and making the transfer of the gift to the trust.
