Understanding how inheritance tax works – in particular the rules relating to individual and married couple allowances, current thresholds and applicable inheritance tax rates – can be key to effective financial planning for the future.
By planning ahead you may be able to minimise any inheritance tax liability after you die and, in turn, maximise the value of your estate for those that you leave behind.
Your estate comprises any money, property and possessions once funeral expenses, administration costs, debts and liabilities have been paid. Any inheritance tax liability will be assessed on the basis of the net value of your estate and will be payable in accordance with the applicable inheritance tax rates at the time of death.
Inheritance tax in the UK
In the UK, the law relating to inheritance tax rates is governed by the Inheritance Tax Act 1984 (as amended). If the net value of your estate falls well below the current thresholds, it can be left to your loved ones entirely tax-free. However, where your estate exceeds these thresholds the financial implications under the inheritance tax legislation – currently standing at 40% – can be significant.
What are the current inheritance tax thresholds?
The inheritance tax ‘nil-rate band’
As the law currently stands (as of April 2018), we are each entitled to an inheritance tax allowance of £325,000. This is known as the inheritance tax ‘nil-rate band’. The net effect is that you are able to pass on to your loved ones up to £325,000 tax-free.
The residence ‘nil-rate band’
Following recent legislative changes, the amount you are able to pass on tax-free has increased significantly by way of a new residence nil-rate band. In addition to the existing inheritance tax threshold, this tax-free property allowance was introduced as a means of allowing individuals to pass on their family home after they die.
Crucially, however, you only qualify for this additional allowance if immediately prior to your death your estate includes a ‘qualifying residential interest’. You do not need to be living in the property at the time of your death. However, it must be a property that at some point during your life you have used as a residence. This means any buy-to-let property you may own would not be eligible for the residence nil-rate band.
Further, the rules state that the qualifying property must be ‘closely inherited’ for the estate to benefit from the new residence nil-rate band. The term ‘closely inherited’ is defined as:
- a lineal descendant, such as a child, grandchild or great grandchild
- a spouse, civil partner or (non-remarried) widow of a lineal descendant.
The definition of child extends beyond blood descendants to include adopted children, step-children, foster children or children for whom the deceased was a court-appointed guardian. However, the rules do not apply to lineal ancestors, ie; parents or grandparents. Further, the rules do not allow siblings, nephews and nieces or any other relatives to benefit from this tax relief if you leave your home to them.
The new residence relief was implemented in April 2017 and is being gradually phased in. The following maximum amounts available are as follows:
- £100,000 (2017-18)
- £125,000 (2018-19)
- £150,000 (2019-20)
- £175,000 (2020-21)
The residence nil-rate band is not an exemption or relief on the residence itself, rather it is set-off against the entire estate. As such, by 2020 you can pass on as much as £500,000 (£325,000 nil rate plus £175,000 residence nil rate band) without your estate incurring any inheritance tax liability.
For estates with a net value of more than £2million, there is a tapered withdrawal of the residence nil-rate band. Here the amount of available relief is reduced by £1 for every £2 of value by which the estate exceeds the tapered threshold. By way of example, a qualifying estate in the tax year 2018/19, valued at £2.25million, would see the residence nil-rate band tapered by £125,000 to nil.
Inheritance tax allowances for married couples
If you are married or in a civil partnership you are allowed to pass your money, possessions and property to your partner, free of inheritance tax.
Further, where one spouse passes away, the surviving partner is entitled to transfer any unused allowances, including the new residence nil-rate band. As such, this can effectively double the amount the surviving partner can leave behind tax-free on their own death. Consequently, by 2020, married couples and civil partners will be able to pass on up to £1 million inheritance tax-free where property forms part of their estate.
Whilst unmarried couples still individually qualify for the residence nil-rate band, they will not be eligible to use any unused allowances from a deceased partner.
What are the current inheritance tax rates (2018-2019)?
The standard inheritance tax rate is currently set at 40%, charged on the part of your residual estate that exceeds the threshold of £325,000. By way of example, if your estate is value at £500,000, you will be liable to pay 40% tax on the additional sum of £175,000 = £70,000 to pay.
This may be significantly reduced if a residence forms part of your estate. Your estate may also be liable to pay a reduced inheritance tax rate of 36% if you gift 10% or more of the net value to charity.
Inheritance tax rates on lifetime gifts
During your lifetime you are able to gift a certain amount of money tax-free. In particular, you have an annual exemption of £3,000 worth of gifts each tax year without them being added to the value of your estate.
Some gifts do not count towards this annual exemption, ie; they are automatically tax-free. This includes gifts between spouses, small gifts made out of your normal income or gifts to charity.
Gifts falling outside these exemptions are known as ‘potentially exempt transfers’ (PETs). Broadly speaking, if a gift is made within seven years of death it may be subject to inheritance tax at a rate of 40%.
However, where a gift is made between three and seven years, the tax becomes payable on a sliding scale. Applying this ‘taper relief’, the inheritance tax rates payable on a gift can be anything between 32% to as little as 8%. Further, after seven years, gifts will not be counted towards the value of your estate.
Who is liable to pay inheritance tax?
Inheritance tax is payable to HM Revenue and Customs by any executor(s) or administrator(s) dealing with the estate. That said, any individuals acting on your behalf after you die are not personally liable to pay the tax due. The funds from your estate will be used to discharge any outstanding debts and liabilities, including any inheritance tax.
Once all debts and liabilities have been paid, the residue of your estate will be distributed in accordance with the terms of your will or, in the absence of a will, under the intestacy rules. Your beneficiaries will not pay tax on the money, property and possessions that they inherit, rather those assets will count towards the value of your estate to establish if any inheritance tax is due in the first place.
Do I need to seek legal advice about inheritance tax rates?
The legislation relating to inheritance tax rates, not least the rules for the new residence nil-rate band can be complex. Moreover, the inheritance tax rates payable on death can have significant financial implications for your loved ones after you die.
A legal advisor specialising in wills, probate and tax planning can advise you on what provision can be made within your will to minimise any inheritance tax liability and will able to provide you with guidance on:
- inheritance tax rates for married couples and civil partners
- inheritance tax rates for unmarried couples
- inheritance tax rates for individuals
- inheritance tax avoidance through tax-free gifts, PETs or otherwise.
In particular, for those whose wealth bracket exceeds £325,000, it is especially important to review and update any will, putting appropriate steps in place to improve the financial position for any partner, children or loved ones who may survive you.