Understanding inheritance tax

7 minutes

Want to ensure your loved ones get the most support possible from your estate? Read on to find out the essential information surrounding inheritance tax, and how to make your money go the furthest.

  • When do you have to pay inheritance tax?
  • Is it possible not to pay inheritance tax?
  • The pros and cons of gifting

Understand how inheritance tax works

The topic of inheritance tax is never a subject that’s going to be easy to talk about with your loved ones. But it is good to understand the ins and outs of the fees that have to be paid to HMRC when somebody passes away, and what can be done to help minimise the impact on your estate.

Before getting concerned about inheritance tax though, it’s worth pointing out that it currently only affects a relatively small number of people. According to statistics published by HMRC, only 3.73% of UK deaths were liable to inheritance tax, or roughly 27,000 estates [1].

Despite these relatively low numbers, it’s still a good idea to understand inheritance tax, and how its impact can be minimised through reliefs and exemptions.


What is inheritance tax?

Benjamin Franklin is widely quoted as saying that there are only two certainties in life – death and taxes. And inheritance tax is a combination of the two.

When somebody dies, their estate – essentially anything they owned, such as property, money and material items – is valued, and the government is able to take a cut of the lump sum before it is passed on to any beneficiaries.

The tax rate is 40 percent, but it is important to point out that you only have to pay inheritance tax when the estate is worth more than a certain amount.


When do you have to pay inheritance tax?

Like most taxes, there is a threshold where you are not required to part with any money. For inheritance tax, the threshold is £325,000. Therefore, if your entire estate is worth less than this, your beneficiaries won’t have to part with a penny of it. You do though have to report it to HMRC regardless.

Anything over this amount is taxed at the 40 per cent rate, but only on the difference between your estate’s value and the threshold. For example, if your estate was worth £400,000, it would only get taxed on the £75,000 that it’s over the threshold – so your inheritance tax bill would be £30,000 in total.

This is generally arranged by the executor if there is a will, with the tax taken out of the estate before it is distributed amongst any beneficiaries.


Is it possible not to pay inheritance tax?

As stated above, if your estate is worth less than the threshold of £325,000 (which is the case for the majority of people), you won’t be liable for inheritance tax. But there are a number of ways to minimise the amount of tax you will have to pay if your estate is valued above.

The first is to leave everything above the threshold to a spouse or civil partner (or a charity or community amateur sports club). In this instance, there’s generally no need to pay any inheritance tax, with your estate just passed on. However, this isn’t always possible, especially if you yourself are a widow or widower.

If you are in this situation, but have children or grandchildren, you are able to give away your home to them, but it will still count towards your estate’s value and therefore could be taxed. The benefit of doing this is that your threshold increases to £500,000, but there will still be tax to pay on anything over this amount.

It is possible to pass on your entire estate to others through gifting without having to pay any inheritance tax, but it requires some forward planning and there are a number of rules to remember.


The pros and cons of gifting

The big plus point of gifting is that it is technically possible to give away your entire estate (even if it’s worth more than the £325,000 threshold) without paying a penny of inheritance tax. However, there are certain barriers to ensure it’s not as simple as that.

The first thing to consider is that there is a seven year rule with gifting. Essentially, anything you’ve gifted in the seven years prior to your death will contribute to your estate’s value. But anything gifted before these seven years is exempt.

For example, if you gift £500,000 of your estate and manage to live another eight years, there will be no tax to pay the £500,000 gift. But if you were to pass away within those seven years, a sliding amount of tax would be owed on any gifts that took the estate’s value passed the £325,000 threshold. In this instance, the beneficiaries are the ones who would have to pay the owed inheritance tax – which can range from 8 to 40 per cent depending on the number of years that had passed since the gift occurred.

Ultimately, there is a big risk in trying to gift your way out of paying inheritance tax on large amounts of your estate. But there are a number of smaller and less hazardous way of supporting your children and grandchildren financially through gift exemptions.