A guide to Inheritance Tax
While only a small percentage of estates are large enough to incur Inheritance Tax, you mustn’t forget to factor this tax into your plans when you make your will. Our guide explains what Inheritance Tax is, how to work out what you need to pay and when, and some of the ways you can reduce this tax.
- What is the Inheritance Tax threshold?
- Who’s responsible for paying the tax?
- How is it calculated?
- When is the tax paid?
- What is exempt from tax?
- How can I reduce the amount of tax paid?
- Using life insurance to pay Inheritance Tax
- What other tax do my heirs have to pay on their inheritance?
What is the Inheritance Tax threshold?
Inheritance Tax is a tax on the property, money and possessions - also known as the ‘estate’ - of someone who’s died.
Each person has a tax-free allowance or ‘nil rate band’ on their estate. Their estate won’t have to pay Inheritance Tax if it’s under this amount. The threshold is £325,000 until 6 April 2021.
Married couples and civil partners are allowed to pass their estate to their spouse tax-free when they die. In other words, the surviving spouse can inherit the entire estate without having to pay Inheritance Tax.
They can also pass on their unused tax-free allowance to their spouse. For example, if a husband dies and leaves his entire estate to his wife, his wife can take his allowance and add it to her own tax-free allowance. This combined allowance means that when she dies, her estate will only incur Inheritance Tax if it’s worth more than £650,000 (£325,000 + £325,000).
From 6 April 2017, everyone has an additional £100,000 (rising to £175,000 by 2020-21) tax-free allowance to use against the value of their home. Also known as the residence nil rate band (RNRB).
They can only get this additional allowance if they leave their home to their children or grandchildren.
This allowance can also transfer to the surviving spouse if it isn’t used up already.
This means by 2020-21, a married couple could leave their heirs a combined estate of up to £1 million without incurring Inheritance Tax.
Who’s responsible for paying the tax?
The tax is normally paid from the funds in the estate, or from money raised from the sale of assets if the estate has no cash.
Sometimes, the deceased has left money in their estate to pay this tax. They might also have arranged for a life insurance policy to cover this bill.
If there is a will, it’s usually the executor of the will who arranges to pay this tax.
If there isn’t a will, it’s the administrator of the estate who does this.
Once the tax and debts are paid, the executor or administrator can distribute what remains of the estate to the heirs.
How is it calculated?
The tax rate is 40% of the estate that is above the threshold. The table below is a simple example of how the tax is calculated for two different estates.
|Estate name||Value of the estate||Amount of taxable estate||Amount of tax due|
The rate may reduce to 36% if at least 10% of the estate is left to charity.
+You’ll need to work out the value of the estate to know how much Inheritance Tax to pay.
Find out how to value an estate in Sorting out the estate when there is a will.
When is the tax paid?
Inheritance Tax is normally paid within six months after the person’s death. If the tax is not paid within six months, HMRC will start charging interest.
HMRC can give the executor of the estate more time to pay the tax if certain assets in the estate, such as property, take a while to sell.
In this situation, your executor can ask to pay the tax in yearly instalments over 10 years. But the outstanding amount of tax will still get charged interest.
If your estate is likely to incur Inheritance Tax, it’s a good idea for your executor to pay some of the tax even before they finish valuing the estate.
This will help the estate avoid getting charged interest if it takes longer to sell the assets to pay off the debts and taxes.
If the executor or administrator is paying the tax from their own account, they can claim it back from the estate.
HMRC will refund the estate if it has overpaid the Inheritance Tax.
What is exempt from tax?
Some gifts and property are exempt from Inheritance Tax, such as wedding gifts and agricultural property.
If the deceased gave a gift in the seven years before they died, that gift is counted as part of the estate, and likely to incur Inheritance Tax.
How much tax is due depends on the value of the gift, when it was given and to whom.
How can I reduce the amount of tax paid?
Trying to reduce how much Inheritance Tax is due on an estate is complicated. But, in short, you can reduce how much tax is paid by:
- Leaving your estate to your spouse or civil partner
- Paying into a pension instead of a savings account
- Regularly giving away up to £3,000 a year in gifts
- Putting your assets into a trust for your heirs
- Leaving a legacy to charity
You’ll only reduce Inheritance Tax on your estate if your life insurance policy is written in trust during your lifetime.
But before you do this, make sure you get professional advice as there might be tax implications in doing this.
Using life insurance to pay Inheritance Tax
Taking out a life insurance policy to pay some or all of an Inheritance Tax bill, can make things easier on your family when it comes time to sort out your estate.
It can help protect your home from having to be sold to pay the Inheritance Tax.
It can also help ensure your gifts to family and friends in the last seven years of your life, are protected from this tax.
In short, it can give you peace of mind that you’re not lumbering your family and friends with a hefty tax bill when you pass away.
In general, it works as follows:
- You set up an insurance policy.
- You specify that the policy is held in trust. If you don’t, the money from the insurance pay-out is counted as part of your estate and subject to Inheritance Tax.
- When you die, the policy pays out to the trust, which might be used to pay all or part of your Inheritance Tax bill.
You might need to set out your wishes in a side letter to guide your policy trust trustees to use the funds in this way.
- It’s a good idea to write your wishes in a separate letter to help trustees follow your instructions.
Estate and tax planning can be complicated, so it’s well worth getting advice to help you make the right decisions for your situation.
If you’re thinking of using life insurance to pay an Inheritance Tax bill, there are two types of policy that you can take out:
1. Whole of life policy
- This type of policy lasts as long as you live, and only pays out when you die, even if it’s very far in the future.
- If you want this kind of insurance, take it out as early as you can.
Premiums are more expensive the older you get. You might also find it’s difficult to get insured when you’re older, or have had health problems.
2. Term insurance policy
- This type of policy lasts a certain amount of time, and only pays out if you die within that time.
- If you’re planning to give away some of your estate in order to reduce the tax, this insurance can help pay that bill if you die within seven years of making those gifts.
- Some term insurance policies can be converted into whole of life policies when they expire.
You need to keep up with the premium payments for the duration of either type of policy, so that it pays out when you die.
What other tax do my heirs have to pay on their inheritance?
Your estate is only distributed after debts (if any) and Inheritance Tax are paid.
But your heirs might incur other types of tax, depending on what they inherit:
- Income Tax - if what they inherit produces a regular income (e.g. share dividends or rent from a property), this is subject to Income Tax
- Capital Gains Tax - if they sell their inheritance (e.g. property) for more money than what it was worth when you passed away, the profit they made on the sale is subject to Capital Gains Tax.
How much they have to pay depends on whether they pay Income Tax at the basic or higher rate.
If you’ve put your assets into a trust or you’re thinking about doing this, how much tax and what kind of tax they have to pay can get very complicated.
You should speak to a tax adviser or solicitor for help in working this out.