Losing a loved one is distressing enough. But if they’ve put you in their will, you may also have to deal with inheritance tax.Here’s a roundup of the inheritance tax rules in the UK. And, because paying too much tax sucks (especially when it’s inheritance tax), we’ll also throw in some tips on how you can minimise or even avoid it altogether.
What is the inheritance tax?
Inheritance tax is a tax on a dead person’s estate. In other words, it’s HMRC taking a slice of the deceased’s property, money and other possessions.
The dreaded tax falls due when a person dies. That said, you may also have to pay it on property, money or other possessions the deceased handed over to you while they were still alive (more on this later).
What is the inheritance tax threshold?
You don’t have to pay any inheritance tax if:
The deceased’s estate is worth less than £325,000 (or £650,000 for a married couple).
You’re the deceased’s spouse or civil partner and they left you everything.
The deceased left everything to someone exempt from inheritance tax, such as a charity, a political party or national institutions such as museums.
If the deceased gave you a gift of money or property during their lifetime, these may be exempt from inheritance tax, as long as they follow HMRC’s rules (we’ll delve into more detail on this later).
The inheritance tax threshold can be passed on between spouses. So, if your estate is worth £200,000, for instance, your spouse or civil partner can add your unused £125,000 to their threshold, increasing it to £450,000.
How much is UK inheritance tax?
Inheritance tax in the UK is currently 40 percent. This rate applies to anything above the tax-free threshold.
Calculating inheritance tax: Example
Let’s say your long-lost uncle names you in his will as his sole heir. The total value of his estate is £500,000.
The first £325,000 would be tax-free. You’d pay inheritance tax at the rate of 40 percent on the remaining £175,000.So, you’d owe HMRC £70,000.
How do you minimise inheritance tax?
If the amount of tax due in our example seems steep, it’s because it is. Luckily, there are things you can do to minimise inheritance tax or even avoid it altogether.
The downside is that it’s mainly up to the deceased to make arrangements that minimise or avoid inheritance tax. So, if you’re concerned about getting hit with a hefty inheritance tax bill, you may have to have a difficult conversation with your loved ones at some point.
Let’s start by looking at how you can minimise inheritance tax.
Minimising inheritance tax: The residence nil rate band (RNRB)
This is known as the home allowance, and the government introduced it in April 2017. The home allowance increases the inheritance tax threshold if the deceased leaves their home to their:
Biological children
Adopted, foster or step-children
Grandchildren or great-grandchildren and their spouses or civil partners
Children under their guardianship
The home allowance is currently £125,000. It’s going to increase by £25,000 in 2019, 2020 and 2021. It’ll then rise in line with the Consumer Price Index in 2022.
The home allowance only applies if the estate is worth up to £2 million. You’ll lose £1 off the allowance for every £2 you go over the threshold. Which means you won’t benefit from the home allowance if the estate is worth £2.25 million or more.
How do you avoid inheritance tax in the UK?
What’s even better than increasing the inheritance tax threshold? Avoiding inheritance tax altogether.As far-fetched as it sounds, it doesn’t involve running away with your inheritance to a secret location in the Caribbean (though that actually does have a nice ring to it, doesn’t it?).
Here are some ways you can legally avoid paying inheritance tax.
Option 1: The annual exemption
HMRC allows you to give up to £3,000 away each year to family and friends, tax-free. This amount is called the annual exemption. You can deduct these amounts from the value of your estate, which means no inheritance tax is due on them.
As a plus, you can carry this exemption forward, but only for one year.
So, if your aunt doesn’t give away anything in 2018/19, she can give away up to £6,000 tax-free in 2019/20. But if she doesn’t give away the £3,000 she carried forward from 2018/19 in 2019/20, she’ll lose it.
Option 2: The seven-year rule
You can avoid paying inheritance tax if you receive money, property or some other possession as a gift and the person who gave it to you lives for at least seven more years. So, if your friend gifts you £100,000 in cash in June 2012, you won’t have to pay inheritance tax on it if he’s still alive in July 2019.Also called the ‘potentially exempt transfer’, because you’ll only know whether it’s actually tax-free in seven years’ time. For the exemption to hold, the deceased can’t give more than £325,000 in the seven-year period.
That said, you won’t necessarily pay the full 40 percent tax if your friend dies before the seven years are up. Potentially exempt transfers are taxed on a sliding scale depending on how long it’s been since you received the gift.
Option 3: Tax-exempt gifts
You and your spouse can give each other as much money and property as you’d like, tax-free, during your lifetimes as long as:
Both of you live permanently in the UK
You lived together for at least part of the tax year in which you gave each other the gift
Either of you didn’t give each other goods for your business to sell on
You received a gift worth £250 or less. This exemption doesn’t count if you also received someone’s full £3,000 annual allowance in a given tax year.
You received a wedding gift. The tax-free thresholds are:
£5,000 from your parents
£2,500 from your grandparents or great-grandparents
Typically the tax will be taken out of the inheritance. Usually, the deceased will have appointed a person to take care of this, called an executor. If there’s no will and you’re the legal heir, you’ll have to designate someone to administer the estate.
What if no inheritance tax is due?
If no inheritance tax is due, you’ll still have to report to HMRC. For this reason, the first thing to do when someone dies is to calculate the total value of the estate.
The executor will usually take care of this. However, here’s how it’s done:
Step 1: Work out the market value of all the estate’s assets and add them up. This exercise will give you the estate’s ‘gross value’. HMRC’s inheritance tax grossing up calculator can help with this.
Step 2: Deduct any debts, such as unpaid mortgages, overdrafts and loans, to find out the estate’s net value. You’ll also need to deduct any tax relief you get on business assets and agricultural assets.
Step 3: Deduct the value of tax-exempt assets. This includes tax-free gifts, anything left to spouses, charities or other tax-exempt beneficiaries and anything gifted seven years or more before the deceased passed away.
Step 4: Deduct £325,000 from the answer in step 3 (or £450,000 if the home allowance applies). You’ll have to pay 40 percent tax on anything that’s left over.
In conclusion
Inheritance tax is perhaps the UK’s most hated tax, and with good reason. It’s a tax on money and property the deceased has probably already paid tax on in their lifetime. And, it’s something you’ll have to deal with at a time when you’ll have more than enough on your plate.
That said, most people don’t have to pay it. According to government figures, only 4 percent of estates are hit with inheritance tax, which means it accounts for less than 1 percent of HMRC’s total tax revenue.
If you follow the tips in this post, you probably won’t have to pay any either when your loved ones pass on.
