Although only a small percentage of people in the UK have estates large enough to incur Inheritance Tax (IHT), it’s important to consider it at the time of making your will. When passed on to the next generation, your children might have to pay as much as 40% of the estate value to the government. You see how useful it is to understand Inheritance Tax, how to find out how much you’ll need to pay and when, and some effective ways of tax planning to reduce this.
What is Inheritance Tax?
An individual’s estate includes all their property, possessions and money they’ve accumulated in their lifetime and left to their children and grandchildren. When someone inherits an estate of high enough worth, they must pay Inheritance Tax to the government.
How Much Inheritance Tax Needs to Be Paid?
No Inheritance Tax applies to your estate if:
- It is below the IHT threshold of £325,000, or
- You leave everything to your spouse/ civil partner, or
- You don’t have survivors and leave your estate to charity
Now, this Inheritance Tax threshold of £325,000 is also the Nil Rate Band (NRB). That is if your estate values below this, no tax is applicable. Then, the part of the estate that’s above this limit is liable for 40% IHT. Let’s look at an example. Suppose your estate is worth £600,000 and your IHT threshold is £325,000. You have to pay 40% on the remaining amount of £275,000 which comes to £110,000. The NRB is set to remain the same at £325,000 till 2021.
What’s the Residence Nil Rate Band?
The Residence Nil Rate Band (RNRB) is also known as home allowance. You can use this home allowance in addition to the Inheritance Tax threshold to reduce the tax. It works such that you should pass on your home or a share in it to your children or grandchildren. Included in this are step-children, adopted as well as foster children but not siblings, nephews and nieces. Providing these conditions are met, RNRB gives you an allowance of £125,000 currently and upto £175,000 by 2020/21. Here’s a table showing how much Resident Nil Rate Band and combined allowances are going to increase in the coming years.
|Years||RNRB (in £)||NRB (in £)||Combined allowances|
Home allowance tapers gradually if the overall estate value exceeds £2 million.
How Does An Executor Value An Estate?
The executor takes two simple figures to arrive at the value of your estate.
- How much your assets are worth at the time of your death
- Any debts and liabilities you may have had are deducted
You should preserve this valuation as HMRC may ask records even 20 years after Inheritance Tax payment. What is inclusive in assets and liabilities?
- Bank account balance
- Land and property
- Payout from life insurance policy
- Jointly owned assets
- Gifts given in seven previous years before the person died
- Gifts given even further back in the past if the recipient is still benefitting from it. Also known as ‘gifts with reservations of benefit’.
Debts & Liabilities-
- Household bills
- Credit card debt
- Gambling debts
- Funeral expenses
Who Pays Inheritance Tax?
If you’ve already made a will at the time of your passing away, the executor named in the will arranges to pay Inheritance Tax (IHT) on the estate. If there’s no will, the administrator of the estate will do this. Inheritance Tax is usually paid with the use of funds from the estate, but if the estate has no cash, assets may have to be sold off to raise money. To avoid this, some people make arrangements beforehand to cover the bill with a life insurance policy. Once debts and tax to the government is clear, the executor/administrator can distribute the estate to the beneficiaries in the way mentioned in your will.
By When Should My Beneficiaries Pay Inheritance Tax?
Generally speaking, Inheritance Tax becomes payable within the first six months after a person’s death. If your beneficiaries don’t pay tax within this timeframe, Her Majesty’s Revenue and Customs (HMRC) will start charging interest. Your executor can pay tax on property in instalments over a period of ten years but the outstanding amount will still accrue interest.
If the executor has to sell the asset before all IHT on it has been paid, they should make sure that all instalments (and interest) have been paid religiously upto that point. A great way your executor can avoid interest on late payment is paying some part of Inheritance Tax within the first six months even if the estate is under valuation. If the executor or administrator pays IHT from their own money, they can claim it back from the estate. You’ll get a refund from HMRC if IHT has been overpaid.
What Are Some of the Gifts and Exemptions on Inheritance Tax?
You can give out a part of your estate as a gift to claim an exemption on Inheritance Tax payment. Some wedding gifts and agricultural property are exempt from IHT. Also important is that the gift is given more than seven years prior to the giver’s death. Else, it could incur tax. Three major factors influence how much IHT you’ll have to pay- value of the gift, when you gave it and to whom.
How Can I Reduce Inheritance Tax?
Tax planning might be tricky but there are ways to get around it. You can reduce the amount of Inheritance Tax by doing the following:
- Leaving your estate to charity organizations
- Writing your assets in trust for your heirs
- Stating your spouse/ civil partner as beneficiary
- Paying into a pension rather than a savings account
- Giving away upto £3,000 a year in gifts regularly
How Can I Use Life Insurance To Pay Off Inheritance Tax?
Inheritance Tax is quite a lot- 40% of what you inherit goes to the tax authorities. So, many wise people take out a life insurance policy to cover the cost of Inheritance Tax. This helps prevent your family from selling off your house to pay IHT. It also protects the gifts you’ve given your family and friends over the last seven years from tax. In short, you get peace of mind that you’re not burdening your loved ones with a hefty bill when you leave them.
How does it work?
- You first take a life insurance policy.
- Don’t forget to set it up in trust, else it would be counted as part of your estate and liable for Inheritance Tax.
- When you die, the policy will pay out to your trust which can be used to pay IHT in full or part.
Estate and tax planning is complicated, so you should seek professional advice in order to make the right decision.
What Other Taxes Would My Heirs Have To Pay In Addition To Inheritance Tax?
Depending on what your heirs inherit, they may also incur
- Income Tax- If they receive a regular income from their assets (share dividends or rent from leased property)
- Capital Gains Tax- If they sold an inherited asset for more value than it was when they inherited it