UK inheritance tax, commonly known as IHT, is the tax payable on the transfer of assets from an estate to its beneficiaries. The current rate for IHT is 40%, which becomes payable if the estate is greater than the inheritance tax threshold once all exemptions and reliefs have been deducted.
What is the inheritance tax threshold?
On your death, all of your assets, i.e. everything you own that is of value, such as property, savings, investments, cars, works of art and jewellery) become your estate.
The transfer of your estate to your surviving spouse or civil partner is IHT-exempt. The only exception to this may be when your spouse or civil partner is non-UK domiciled away from the UK, in which case you are advised to take advice on your specific circumstances.
Other exempt beneficiaries include:
- Eligible charities
- Eligible political parties
- Certain national institutions including museums
The current inheritance tax threshold, or ‘nil-rate band’, is £325,000. In the most basic terms, if your estate exceeds this level, it will become liable to the IHT rate of 40%. This threshold was introduced in 2009/10 and has been frozen by the government until 2020/21.
Transferring the nil rate band to increase your inheritance tax threshold
Widows and widowers can benefit from an increased threshold if their deceased spouse did not use all their allowance. In such cases, the first spouse’s nil rate band is effectively transferred to the estate of the second spouse. For example, if your spouse left their entire estate to you, their nil rate band would remain in tact and transfers to your estate, doubling your threshold to £650,000.
Main Residence allowance
This Main Residence allowance was introduced in 2017/18 and puts in place a supplementary nil-rate allowance of £100,000 for home owners transferring property to close relatives.
There are strict conditions attached to the main residence allowance. The property must have been the residence of the deceased at some point, which means it cannot be used on buy to let properties. The allowances also only applies to the transfer to close relatives, which include spouse, children and/or grandchildren. This includes adopted, fostered or step children.
The main residence allowance is being increased year on year to £175,000 by 2020/21.
If you combine the standard IHT threshold and the main residence allowance this means that in 2020/21 couples that are married or in a civil partnership will have a combined inheritance tax allowance of £1m. The main residence allowance is however will be tapered away if your total estate (Ie not just the property) is worth more than £2 million.
Where your estate is exceeding the Inheritance tax threshold, you may wish to explore options to bring the size of your estate down, through effective use of estate planning tools such as certain types of trusts, and lifetime gifts.
A bare trust has a definitive list of beneficiaries and set distribution of capital and income, neither of which can be changed once the trust has been created.
Gifts made under a bare trust are classed as ‘potentially exempt transfers’ (PETs). If the settlor lives at least seven years after making the trust ie PET, the assets in the trust will no longer come under IHT.
This allows you to pass any amount up to the current IHT threshold into a trust, with all other assets moving tax free to your surviving spouse. Designated trustees can give money to anyone who is named as beneficiary at their discretion. If the surviving spouse is a named beneficiary they may choose to receive money as a loan to avoid increasing their estate. An added benefit being that interest on this loan can roll up and further offset their future inheritance tax.
Discretionary trusts can still play a role in inheritance tax planning particularly when:
A widow/er has already inherited a second nil rate band therefore is not permitted to inherit another
There has been a remarriage and the inheritance for the children from the first marriage needs to be protected
There is a need to protect assets in the estate against care or home costs
Accumulation and maintenance trusts
This is a form of discretionary trust where beneficiaries must be under 25 when it comes into force and at least one beneficiary must become entitled to receive income from the trust by the age of 25. Accumulation and maintenance trusts are often used for the planning of school fees and gifts to current and future grandchildren.
Interest in possession trust
This type of trust is employed where a settlor wants beneficiaries to receive trust income or make use of trust property but doesn’t want them to be able to dispose of such assets until a specified age. They can also be used if a settlor wants one person to benefit from a trust before passing it onto another beneficiary. For example, a widow receives trust income from her deceased husband before it is then passed to their children on her death.
The beneficiary of an absolute trust is entitled to receive all income from the trust and, with the exception of parental settlements, it is treated as their own for tax purposes. If the beneficiary is over 18 they can ask for the trusts assets to be transferred in full to them at any time.
Trusts can still play a big role in inheritance preparation but need careful planning. Due to the complex nature of trusts seeking professional advice before entering into such an arrangement is essential.
Making ‘inter vivo’ gifts
‘Inter vivos’ are gifts made during your lifetime, to effectively reduce the size of your estate and resulting IHT liability.
If you expect your estate to be subject to inheritance tax, making full use of gifting can help to increase benefit to your loved ones.
Gifts can be any assets including money, jewellery or property and are known as a PET (potentially exempt transfers) as they will be subject to IHT on a tapered scale should you die before 7 years of making the gift. The amount of tax varies depending on how many years have passed since the gift – on a sliding scale called taper relief.
Even with a modest estate these ‘in lifetime’ gifts need to be thoughtfully considered. All UK residents have a yearly gift exemption of £3000 and in addition you can make as many small gifts of £250 to different parties as you like. £3,000 in gift allowance can be carried over to the next tax year but before using this you must first use your allowance from the current tax year.
There are some gifts that are exempt from inheritance tax:
- Married couples exemption: Gifts between husband and wife/civil partners are not subject to IHT so you can give as much as you like at any point in life – as long as they are permanent UK residents.
- Wedding Gifts: Gifts of up to £5000 can be given IHT free to children/ stepchildren, gifts of up to £2500 can be given to grandchildren/great grandchildren IHT free and to other relatives or friends gifts of up to £1000 are IHT tax free.
- Gifts to help with living costs: Gifts to a former spouse, elderly dependent or child in full time education are exempt from IHT.
- Surplus income: If you have sufficient income for your standard of living you can make tax free gifts as long as they are regular and recorded properly. If you plan this could be used for Christmas presents, contributions to savings plans or even the rent of dependants.
- Charities: Registered charities, museums, universities and some community organisations can benefit from gifts IHT tax free. Gifting over 10% of your estate to charity means IHT on the rest of your estate is reduced to just 36%.
- Political parties: Political parties can receive IHT free gifts as long as they meet certain conditions.
Planning and legal advice
The rules surrounding the inheritance tax threshold are notoriously complex, and subject to frequent change.
Taking a proactive approach can help to reduce the size of your taxable estate and the resulting liability to IHT. Depending on your circumstances, you may also consider alternative forms of tax planning and structures for IHT relief, including business property and agricultural relief.
Setting out an estate plan as early as possible can help you ensure financial security for you, your spouse and any dependents. Instructing a specialist solicitor is the best way to ensure your wishes are respected on death.