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What is Inheritance Tax? How Do I Calculate It & How Can I Avoid It?

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What is Inheritance Tax?

In the UK, inheritance tax is a tax payable on the estate — the collection of the assets you own at the date of your death — of an individual who has died.

If your total estate is worth more than £325,000 (known as your nil-rate band), you’ll typically pay inheritance tax on any sums above this. Just how much inheritance tax you pay will depend on the value of your estate, which includes assets such as:

  • Cash
  • Jewellery, cars, furniture etc.
  • Most stocks and shares
  • Most other financial assets
  • Homes and non-agricultural land
  • Life Insurance policies not written into trust.

All UK nationals are subject to inheritance tax on their belongings and assets, wherever those assets may be in the world.

How Much is Inheritance Tax?

Inheritance tax is due at 40% on anything you own as a single individual above the £325,000 nil-rate band.

There are a number of thresholds which make up your Inheritance Tax Allowance – under these thresholds, no inheritance tax is due on your estate.

Nil-Rate Band Allowance

As of the current (2019/20) tax year, each individual has a nil-rate band allowance of £325,000

Main Residence Nil-Rate Band

In the 2017/18 tax year the main residence allowance was set at £100,000 and will gradually rise in future years, reaching £175,000 by 2020/21. It can be used when your main residence is passed to a direct descendant.

For those with larger estates worth more than £2 million, the residence nil-rate band is tapered down by £1 for every £2 your estate is over £2 million. So, if your estate is worth £2.3m in the 2019/20 tax year, you’ll lose the entire main residence nil-rate band.

Anyone who chose to ‘downsize’ or sell their main residence after July 8th 2015 to move into residential care or the home of a relative, will have their main residence allowance protected providing any replacement property or assets that might arise form part of their estate that is passed to their descendants.

Transferable Nil-Rate Band

You can also transfer any unused nil-rate band and main residence nil-rate band to your spouse / civil partner providing you leave everything to them in your will, which means the inheritance tax threshold for couples by 2020/21 stands at potentially up to £1 million.

Tax Year

Nil-Rate Band

Residence Nil-Rate Band

Combined Nil-Rate Bands for Individuals*

Combined Nil-Rate Band for Couples**

2017/18

£325,000

£100,000

£425,000

£850,000

2018/19

£325,000

£125,000

£450,000

£900,000

2019/20

£325,000

£150,000

£475,000 

£950,000

2020/21

£325,000

£175,000

£500,000

£1 million

* — providing a main residence is being passed to direct descendants ** — up to this figure providing everything is left to the surviving spouse

After 2020/21, the residence nil-rate band will rise in line with CPI inflation.

Assuming you’re passing your main residence down to direct descendants, this provides a couple with up to £1 million to leave to their heirs without any inheritance tax being due by 2020/21.

Inheritance Tax Calculation for a Single Individual

Harry is a single individual who rents rather than owns his home. He has an estate worth £500,000 that he wants to pass down to his beneficiaries.

To work out how much inheritance tax you have to pay on the estate, you take the total value of his estate (£500,000) and take away his nil-rate band threshold (£325,000).

This provides a total taxable estate of £175,000.

Inheritance tax to pay on a £500,000 estate:
£175,000 x 40%
£70,000

Inheritance Tax Calculation for Couples

As mentioned above, a couple in the 2020/21 tax year will have an allowance of £1 million to pass down to their beneficiaries providing the estate contains a main residence they’re leaving to direct descendants.

Imagine James and Alice are married. They have two sons, Joe and Steve.

James dies in the 2019/20 tax year and leaves everything to Alice in his will.

There’s no inheritance tax to pay when James dies because he left everything to his spouse, and transfers between spouses are exempt from inheritance tax. As he left everything to Alice, Alice’s nil-rate band and main residence nil-rate band are doubled.

Alice passes away during the 2020/21 tax year with an estate worth £1.3 million when the nil-rate band is £325,000 and the residence nil-rate band is £175,000. This £1.3 million estate includes a main residence she intends to pass to her sons.

As she inherited both of James’ allowances in full, she can leave an estate of £1 million in the 2020/21 tax year without her sons having to pay inheritance tax.

To calculate the total inheritance tax bill on Alice’s estate, you deduct the nil-rate bands owed to her and James and then deduct their doubled main residence nil-rate bands to find the taxable estate.

Inheritance Tax Calculations for Alice’s Estate in 2020/21

Total estate:

£1.3 million

Less James’ nil-rate band:

-£325,000

Less Alice’s nil-rate band:

-£325,000

Less James’ main residence nil-rate band:

-£175,000

Less Alice’s main residence nil-rate band:

-£175,000

Total taxable estate:

£300,000

Inheritance tax due:
£300,000 x 40%
£120,000

Inheritance Tax and a Proportion of the Nil-Rate Band

It’s important to note that it’s a percentage (%) of the remaining nil-rate that’s passed on death, not its cash (£) value. If you die and leave half of your nil-rate band to your spouse / civil partner, the surviving partner will be entitled to half of the monetary value of the nil-rate band available at the time of their death, rather than at the time of the first partner to die.

Imagine Tom and Peter are civil partners who rent rather than own their home. They have one daughter, Mary. When Tom dies in January 2019, he leaves £162,500 to Mary, using up half of his £325,000 nil-rate band, and the remainder of his estate to Peter. Peter therefore inherits 50% of his Tom’s nil-rate band, which can be added to his nil-rate band on his death.

Peter dies 10 years later with an estate worth £500,000. At this point, let’s say the nil-rate band has increased to £400,000. Peter is therefore able to leave to Mary a total estate of £400,000 (his nil-rate band at date of death) plus 50% of Tom’s used nil-rate band valued at the date of Peter’s death (£200,000). Mary can therefore inherit a total of £600,000 without any inheritance tax being due. As Peter’s estate is only worth £500,000, no inheritance tax is due.

Had Tom left everything to Peter at the date of his death, Mary could have inherited £800,000 from Peter tax-free when Peter died 10 years later.

Inheritance Tax Calculator

Simply follow these four quick steps to work out your potential inheritance tax liability.

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Paying Inheritance Tax

If you’re dealing with the estate of someone who has died, you need to provide a value of the estate as part of applying for probate. This is a legal process that gives you the right to deal with the affairs and assets of the person who has died.

If the deceased left a will, this is known as applying for a grant of probate. If they did not leave a will, you apply for letters of administration and the process is slightly different.

To apply for probate, you’ll need to know the value of the estate.

How to Value an Estate for Inheritance Tax Purposes

  • Calculate their assets and liabilities
    This may involve writing to banks, building societies, pension providers, companies they hold shares in etc. (to get a picture of their assets) as well as utilities, mortgage companies, credit card lenders etc. (to work out their liabilities)
  • Value the estate to check if there’s inheritance tax due
    If the estate is passing to the deceased’s spouse / civil partner or a charity / political party / amateur sports club or the total value of the estate is below £325,000 then inheritance tax is not usually payable. This threshold may be higher if a person’s spouse / civil partner died before them or they’re leaving their main residence to direct descendants (see above)
  • Estimate a ‘gross’ value of the estate
    This is all assets, plus any gifts (e.g. cash) given away in the 7 years before an individual died (and potentially up to 14 years if the individual has previously made gifts into certain trusts). If the person gave away more than £325,000 in the 7 years before passing away, the recipients may have to pay inheritance tax on the gifts they received. Don’t deduct any debts yet.
  • Report the ‘gross’ value to HMRC
    When you report the gross value of the estate to HMRC, you also calculate its ‘net’ value — which is assets plus gifts minus debts. It’s this net value you’ll require if you need to apply for probate. At this point, you may need to get more accurate valuations of items, including professional valuations for things over £500. However, estimates will continue to be fine if the total estate is worth less than £250,000 or everything is passing to the deceased’s spouse or civil partner.
  • Pay any inheritance tax that’s due
    If the estate is worth over the inheritance tax thresholds available, you’ll typically need to pay at least some of the inheritance tax bill before receiving probate clearance to finalise the person’s estate and begin distributing funds to beneficiaries. You can usually claim the tax back from the estate or the beneficiaries if you pay it out of your own bank account.

Who Pays Inheritance Tax?

Inheritance tax is typically paid out of the estate of the deceased.

At least some inheritance tax must usually be paid before a grant of probate can be supplied. Liquid funds within the estate, such as cash in bank accounts, are typically used to cover the inheritance tax bill.

Where there are insufficient liquid funds in the estate to pay the bill, which can happen if the bulk of the estate is made up of property or shares, things get a little more complicated.

It usually falls to the person dealing with the estate – known as the executor if the deceased left a will – to cover the inheritance tax bill so probate can be granted and the estate released. The executor can then recoup these funds from the estate when it is later liquidated and distributed as per the deceased’s wishes.

Alternatively, if the executor(s) cannot afford to pay the inheritance tax bill, they can take out a loan from a bank against the value of the estate, which banks are fairly well-versed at supplying.

Inheritance Tax on Gifts

Where an individual makes gifts above the value of their nil-rate band within 7 years of their death, the onus is on the recipient(s) of the gift(s) to pay the inheritance tax bill. This is paid on a sliding scale depending on how long you live after making the gift.

When Do I Have to Pay Inheritance Tax?

HMRC will expect the appropriate forms to be filed within 12 months of the death and at least an initial inheritance tax payment (if necessary) to be made within 6 months of the death. If inheritance tax is due, late payments will come with an interest charge.

For property or other assets that take time to sell, you may have the option to pay inheritance tax in yearly instalments. However, there will be interest charged on these instalments.

You will not pay any interest on the first instalment (unless you pay late), but on each later instalment you pay interest on both:

  • The full outstanding tax balance.
  • The instalment itself, from the date it’s due to the date of payment (if it’s paid late).

Assets that allow you to pay inheritance tax in instalments:

  • Homes
    You can pay 10% and the interest each year if you decide to keep the house to live in.
  • Shares and securities
    You can pay in instalments if the shares or securities allowed the deceased to control more than 50% of a company.
  • Unlisted shares and securities
    You can pay in instalments for ‘unlisted’ shares or securities (ones not traded on a recognised stock exchange) if they’re worth more than £20,000 or they represent a significant share of the company.
  • Business run for profit
    You can pay in instalments on the net value of a business, but not its assets.

In certain other cases, you may be able to pay inheritance tax in instalments if:

  • At least 20% of the total inheritance tax due is made up of assets qualifying for instalment payments
  • Paying Inheritance Tax in one lump sum will cause financial difficulties.

Avoiding Inheritance Tax: Gifts, Reliefs and Exemptions

If you’re facing an inheritance tax bill, you can take steps while you’re still alive to reduce the amount of inheritance tax you’ll have to pay.

The first is to make sure you’re taking advantage of all reliefs and exemptions available to reduce the value of your estate without having to pay inheritance tax.

Firstly, it’s essential you make a will. This gives you much more control over how your assets will be distributed after your death and allows you to make use of the spousal exemption if you’re married or in a civil partnership, for example, whereby anything you gift to your spouse while you’re alive (or indeed after you pass away) is always free from inheritance tax.

That’s when the potentially doubled nil-rate band and residence nil-rate bands can come in with a properly-structured will that ensures spouses / civil partners leave everything to each other.

Gifts to charities, political parties, amateur sports clubs are also free from inheritance tax, with inheritance tax falling from 40% of assets over the nil-rate band to 36% of assets over the nil-rate band if you leave at least 10% of your ‘net’ estate to charity.

Inheritance Tax and Gifts

The rules are far more complicated when it comes to gifts to those other than your spouse / civil partner, with strict limits in place on what gifts you can give away without inheritance tax being due. You have six main gifts limited in monetary value you can make each tax year without having to worry about inheritance tax:

  • The annual gift exemption
    Allows anyone to gift up to a combined total of £3,000 in each tax year (6 April to 5 April) to whoever they chose. You can carry over up to £3,000 in unused IHT allowance from one tax year to the next, but you must use up all of your allowance in that tax year.
  • Small gifts exemption
    Small gifts of up to £250 can be made to as many people as you choose – although you can’t use your annual exemption and your small gift exemption on the same person in the same year.
  • Wedding gifts
    You can gift up to £5,000 to your children / stepchildren as a wedding gift. Smaller allowances are available for grandchildren (£2,500) and wedding gifts to friends or other relatives (£1,000).
  • Gifts to charities or political parties
    Certain gifts to political parties as well as those to charities, museums and universities are free from IHT. If you leave more than 10% of your estate to charity, your overall IHT rate is reduced to 36%.
  • Gifts for living costs
    Help a former spouse, elderly or disabled dependent or child under 18 in full-time education with their living costs without any inheritance tax liability.
  • Gifts out of excess income
    This covers regular gifts only, such as Christmas and birthday presents, but you must prove that you are able to maintain your current standard of living after making said gifts. The gifts must form a pattern of gift-giving to pass this test and the rules are complex – seek advice before attempting to reduce your estate via this avenue.

Inheritance Tax and Potentially Exempt Transfers

You can of course give away more than this, but be warned. Large gifts made during your life are only classed as potentially exempt transfers, meaning that they’re only potentially exempt from inheritance tax.

To be fully exempt, you must live at least 7 years after making the gift (and potentially up to 14 years if you’ve previously made gifts into certain trusts).

If you fail to live for 7 years after making the gift, inheritance tax may be due. If the total sum of the gifts you’ve given in the 7 years prior to your death exceed your available nil-rate band, then the recipient of the gift may have to pay inheritance tax.

This becomes known as a ‘failed PET’ and tax will be due on a sliding scale under the taper relief rules, as per the table below.

Taper Relief on Gifts

If you’ve given away gifts above the value of your nil-rate band in the 7 years before death, the onus falls on the recipient(s) of the gift(s) to pay the inheritance tax bill. Inheritance tax on gifts falls the longer between the giving of the gift and the date of the gift-giver’s death thanks to taper relief.

Years Between Gift and Death

Tax Paid

Less than 3

40%

3-4

32%

4-5

24%

5-6

16%

6-7

8%

7+

0%

Using Trusts to Reduce Inheritance Tax

You can also use trusts to reduce your inheritance tax bill, although beware this is unlikely to remove your inheritance tax bill entirely.

Trusts are NOT usually entirely free from inheritance tax. For most types of trust, inheritance tax is charged at a lesser rate (20%) on assets ‘settled’ into the trust – this is known as the lifetime rate because most gifts into trust are chargeable lifetime transfers (CLTs). 

There may be further inheritance tax due depending on the gap between you making the gift and your death. If the settlor dies within 7 years (and potentially up to 14 years), up to an additional 20% could then be charged to bring it up to the IHT charge on death.

The inheritance tax bill on setting up most trusts will be the value of the property ‘settled’ into the trust, less any inheritance tax allowance you haven’t used in the last seven years. So, if you placed assets worth £400,000 into trust and hadn’t used your allowance elsewhere, you would generally pay £15,000 (20% of the £75,000 in excess of the £325,000 allowance).

A 10-year charge (where the assets held in the trust are revalued every decade and taxed) and an exit charge (when the trust is wound up and the asset(s) held inside retrieved from trust) will also typically apply.

Trusts are complicated and definitely one area we wouldn’t recommend going it alone.

For expert advice on how to set up a trust, including the costs involved and how much inheritance tax is due on trusts, don’t hesitate to get in touch.

Jonathan Cooper
Senior Paraplanner at Drewberry

Inheritance Tax Reliefs

There are some assets that don’t attract any inheritance tax. These include:

Businesses / Shares in a Business

Business property relief is available at 100% a business or an interest in a business or shares in an unlisted company.

50% business property relief is available on:

  • Shares controlling more than 50% of the voting rights in a listed company;
  • Land, buildings or machinery owned by the deceased and used in a business they were a partner in
  • Land, buildings or machinery used in the business and held in a trust that it has the right to benefit from.

You can only get relief if the deceased owned the business or asset for at least 2 years before they died.

Note that business property relief isn’t available on companies that:

  • Mainly deal with securities, stocks or shares, land or buildings, or in making or holding investments
  • Are not-for-profit organisations
  • Are being sold, unless the sale is to a company that will carry on the business and the estate will be paid mainly in shares of that company
  • Are being wound up, unless this is part of a process to allow the business of the company to carry on.

BPR-qualifying investments are high risk and can be difficult to sell. The value of the investment and the income from it can fall as well as rise and investors may not get back what they originally invested, even taking into account the tax benefits.

Agricultural Property

You can pass on some agricultural property without paying inheritance tax. ‘Agricultural property’ is defined as land or pasture that is used to grow crops or to rear animals intensively. It also includes:

  • Growing crops
  • Stud farms for breeding and rearing horses and grazing
  • Trees that are planted and harvested at least every 10 years (short-rotation coppice)
  • Land not currently being farmed under the Habitat Scheme
  • Land not currently being farmed under a crop rotation scheme
  • The value of milk quota associated with the land
  • Some agricultural shares and securities
  • Farm buildings, farm cottages and farmhouses.

These do not qualify for Agricultural Relief:

  • Farm equipment and machinery
  • Derelict buildings
  • Harvested crops
  • Livestock
  • Property subject to a binding contract for sale.

Woodland Property

If your estate includes woodland property, you must include this in the value of your estate even though it’s not taxable.

The land itself is not typically subject to inheritance tax; however, the trees on the property are subject to the tax if it’s sold or given away as timber.

Heritage Assets

To qualify for the heritage assets relief, the assets must be one of the following:

  • Buildings, estates or parklands of outstanding historical or architectural interest
  • Land of outstanding natural beauty and spectacular views
  • Land of outstanding scientific interest including special areas for the conservation of wildlife, plants and trees
  • Objects with national scientific, historic or artistic interest, either in their own right or due to a connection with historical buildings.

The new owner must make an agreement, known as ‘the undertakings’ to:

  • Look after the item
  • Make it available for the general public to view
  • Keep it in the UK.

If the owner does not keep to the agreement or sells the asset, the exemption is withdrawn and the tax must be paid.

Inheritance Tax Insurance

Depending on your circumstances, there are two ways you can structure an insurance policy to pay your inheritance tax liability:

  • Whole of Life Insurance
    An insurance product that protects you for your whole life and pays out eventually when you die, whenever that may be. This is opposed to the more common term assurance policies, where the term is fixed for a set period and you only receive a payout if you die within that period (say for 25 years after the policy’s live date). This guaranteed payout can then be used to pay an inheritance tax bill at the date of death.
  • Gifts Inter Vivos Insurance
    A structured decreasing term insurance policy designed to match the taper relief on gifts to ensure any potential tax liability is covered should the individual pass away within 7 years of making it.

Inheritance Tax Insurance for Gifts: Illustration

Julia was single (not married or in a civil partnership) when she passed away in May 2019.

In the 7 years before she died, she made three major gifts inter vivos:

  • £200,000 to her niece Susan 5 years before passing away
  • £200,000 to her nephew Matthew 3 years before her death
  • £100,000 to her friend Rosa 2 years before her death.

Julia has no entitlement to any other exemptions or reliefs.

The £325,000 inheritance tax threshold stands; gifts under this attract no inheritance tax. The inheritance tax threshold is applied to gifts chronologically in the order they were made.

£200,000 is used up by the gift Julia gave to her niece Susan 5 years before passing away. There’s no tax to pay on his gift because it’s under the £325,000 threshold.

The remaining £125,000 is used up by her £200,000 gift to her nephew Matthew. Inheritance tax is due on the amount not covered by the threshold. That means there’s tax to pay on £75,000 of the gift to Matthew at a rate of 32% (thanks to the taper relief available given the length of time between Julia giving the gift and passing away).

Tax for Matthew to pay on his gift:
£75,000 x 32%
£24,000

The £100,000 gift given to her friend Rosa is not eligible for taper relief because it was only made 2 years prior to her death. Therefore, tax is due on the £100,000 at 40%.

Tax for Rosa to pay on her gift:
£100,000 x 40%
£40,000

Julia’s remaining estate was valued at £500,000 and charged at the usual 40% inheritance tax rate. There was no nil-rate band remaining to use against the value of her estate because it had all been used by her gifts.

Tax to pay on Julia’s remaining estate:
£500,000 x 40%
£200,000

Fortunately, Julia purchased Inheritance Tax Insurance before she passed away for the gifts she left.

This was written into trust and paid out on the date of her death to meet the outstanding liabilities Matthew and Rosa faced on their gifts.

Need Inheritance Tax Advice?

Inheritance tax is a complicated area, especially when you start to attempt to reduce a potential inheritance tax liability with measures such as trusts and Life Insurance policies.

If you would like to discuss your options with one of our experts please do not hesitate to give us a call on 02084327334 or email help@drewberry.co.uk.

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25/07/2019
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