A guide to Inheritance Tax

Only a small percentage of estates are large enough to incur Inheritance Tax (IHT), but you mustn’t forget to factor this tax into your plans when you make your will. Our guide explains what IHT is, how to work out what you need to pay and when, and some of the ways you can reduce this tax.

What is Inheritance Tax?

Inheritance Tax (IHT) is a tax on the estate of someone who has died, including all property, possessions and money.

How much is Inheritance Tax?

There is normally no tax to be paid if:

  • The value of your estate is below the IHT threshold of £325,000, or
  • You leave everything to your spouse or civil partner, or
  • You leave everything to an exempt beneficiary such as a charity

If the value of your estate is above the nil rate band (NRB) of £325,000; then the part of your estate that is above this threshold will be liable for tax at the rate of 40%.

So, if your estate is worth £525,000 and your IHT threshold is £325,000, the tax charged will be on £200,000 (£525,000 - £325,000). The tax would be £80,000 (40% of £200,000).

The NRB is fixed at £325,000 until 2021.

The Residence Nil Rate Band (RNRB) – also known as the home allowance -has been introduced recently.

The home allowance is on top of the NRB. To be eligible you must pass your home or a share of it to your children or grandchildren.

This includes step-children, adopted children, foster children but not nieces, nephews or siblings.

Provided certain conditions are met, the home allowance gives you an additional allowance to be used to reduce the IHT against your home.

The home allowance is currently £125,000, but it will rise incrementally to reach £175,000 in 2020/21 and in line with the Consumer Price Index thereafter.

This table shows the increases of the RNRB and the potential combined allowance:

Resident Nil Rate Band and combined allowances in coming years
  Resident Nil Rate Band (£) Nil rate band (£) Combined allowances
2018-19 125,000 325,000 450,000
2019-20 150,000 325,000 475,000
2020-21 175,000 325,000 500,000

There is tapered withdrawal of the home allowance if the overall value of your estate exceeds £2 million.

You can read more about the home allowance and the conditions hereopens in new window.

How to value the estate

To value an estate you will need to:

  • List out all the assets and work out their value at the date of death
  • Deduct any debts and liabilities

Remember to keep records of how you worked it out, such as estate agent’s valuation.

HMRC can ask to see records up to 20 years after Inheritance Tax (IHT) is paid.

Assets include items such as money in a bank, property and land, jewellery, cars, shares, a pay-out from an insurance policy and jointly owned assets.

A more detailed list can be found on Lawpack or on Gov.uk

Gifts also need to be included, such as cash or other assets, if they were given away in the seven years before the person died.

You’ll also need to include any gifts given before this period if the person who died continued to benefit from the gift.

These are also known as ‘gifts with reservations of benefit’. For example, they gave away their house but continued to live in it.

Debts and liabilities reduce the value of the deceased’s chargeable estate. Think about items such as household bills, mortgages, credit card debts, gambling debts and some funeral expenses.

Visit the GOV.UK website for more information on working out what part of an estate is liable for Inheritance Tax.

Who pays Inheritance Tax?

If there is a will, it’s usually the executor of the will who arranges to pay the Inheritance Tax (IHT).

If there isn’t a will, it’s the administrator of the estate who does this.

The IHT is normally paid from the funds in the estate, or from money raised by the sale of assets if the estate has no cash.

Sometimes, the person who died has left money in their estate to pay this tax. They might have arranged for a life insurance policy to cover this bill.

Once the tax and debts are paid, the executor or administrator can distribute what remains of the estate to the heirs.

When do you have to pay Inheritance Tax?

Inheritance Tax (IHT) should normally be paid within six months after the person’s death. If the tax is not paid within this timeframe, HMRC will start charging interest.

The executors can choose to pay the tax on certain assets, such as property, by instalment over ten years, but the outstanding amount of tax will still get charged interest.

If the asset is sold before all the IHT is paid, the executors must ensure that all instalments (and interest) are paid at that point

If your estate is likely to incur IHT, it’s a good idea for your executor to pay some of the tax within the first six months of death, even if they haven’t finished valuing the estate. This will help to avoid interest for late payment.

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 IHT.

Visit the GOV.UK website for more information on Inheritance Tax, including valuing the estate and paying the tax and trusts.

Inheritance Tax gifts and exemptions

Some gifts and property are exempt from Inheritance Tax (IHT), such as some wedding gifts and agricultural property.

If the person who died gave a gift in the seven years before they died, it’s counted as part of the estate, and likely to incur IHT.

How much tax is due depends on the value of the gift, when it was given and to whom.

Find out more about what is Exempt from Inheritance Tax.

How can I reduce the amount of tax paid?

Trying to reduce how much IHT is due on an estate is complicated. But, in short, you can reduce how much tax is paid by:

  • Leaving a legacy to charity
  • Putting your assets into a trust for your heirs
  • 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
Learn more about how to Reduce your Inheritance Tax bill.

Using life insurance to pay Inheritance Tax

Take advice

You’ll only reduce IHT on your estate if your life insurance policy is written in trust during your lifetime. If your life insurance policy is not written into a trust the policy proceeds will count towards the value of your estate and be liable to IHT on your death.

Make sure you get professional advice as there might be tax implications in doing this.

Taking out a life insurance policy to pay some or all of an Inheritance Tax (IHT) 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 IHT.

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 you’re not lumbering your family and friends with a hefty tax bill when you pass away.

How it works

  • You set up an insurance policy.
  • You specify 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 IHT.
  • When you die, the policy pays out to the trust, which might be used to pay all or part of your IHT 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.

Estate and tax planning can be complicated, so it’s well worth getting advice to help you make the right decisions for your situation.

Find out how to choose a financial adviser.

If you’re thinking of using life insurance to pay IHT, there are two types of policy 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.
Read our guide to learn more about Whole of life policies.

2. Term insurance policy

  • This type of policy lasts a certain amount of time, and only pays out if you die within the stated period.
  • If you’re planning to give away some of your estate to reduce the tax, this insurance can help pay bills 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 it pays out when you die.

Learn more about Term insurance policies.

What other taxes do my heirs have to pay on their inheritance?

Your estate is only distributed after debts (if any) and Inheritance Tax (IHT) are paid.

Depending on what they inherit, your heirs might also incur:

  • Income Tax - if what they inherit produces a regular income (e.g. share dividends or rent from a property)
  • Capital Gains Tax - if they sell their inheritance (e.g. property) for more money than what it was worth when you died. 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.

Visit the GOV.UK website to learn more about what tax your heirs will need to pay on their inheritance.

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