The financial implications of inheritance tax can be significant, potentially draining large sums from the legacy left for loved ones. In the last tax year alone, this levy contributed a substantial £7 billion to HM Revenue & Customs. Inheritance tax has come under the spotlight in recent years and there are rumours that it may be subject to significant changes in next week’s budget. Ahead of any potential changes, below is a recap of the current position.
With property prices soaring in recent years and the inheritance tax threshold frozen until April 2028, more individuals could find themselves entangled in this process.
However, the paradox lies in the fact that, in practical terms, approximately 96% of individuals escape this tax entirely. For the minority impacted, legal avenues exist that could help to strategically sidestep substantial portions of it.
This guide outlines five crucial aspects of inheritance tax that are essential for individuals to understand when tax planning.
1. Anything left to a spouse or civil partner is EXEMPT from inheritance tax
In reality, the impact of this tax is far from universal, affecting only approximately 4% of families, primarily because most estates comfortably reside below the inheritance tax threshold.
A significant factor in this exemption is the marital or civil partnership status of the departed individual. When assets are bequeathed to a surviving spouse or civil partner, they enjoy complete immunity from inheritance tax, irrespective of the estate’s estimated value. This means that even if the departed possessed a million pounds at the time of passing, directing the entirety to the surviving spouse or civil partner renders it immune from inheritance tax. It is worth noting that portions not bequeathed to the spouse or civil partner might still be subject to inheritance tax.
However, this crucial exemption does not extend to unmarried couples cohabiting, regardless of the duration of their shared life or the number of offspring. In essence, if you reside with your partner without the legal bond of marriage or civil partnership, any bequest to your partner upon your death contributes to your individual inheritance tax-free allowance.
According to the Office for National Statistics, in England and Wales, fewer than 50% of individuals over the age of 16 are married or in a civil partnership, underscoring the prevalence of diverse relationship structures in contemporary society.
2. You do not pay inheritance tax on the first £325,000 you leave to other people
Even if a portion of your estate is designated for someone other than your spouse or civil partner, the likelihood of incurring inheritance tax remains relatively low. This is attributed to the universal provision of a £325,000 inheritance tax-free allowance granted to everyone.
Therefore, if the total value of the estate, excluding anything bequeathed to a spouse or civil partner, falls below £325,000, no inheritance tax is applicable. It’s worth noting that the same exemption applies if the entire estate exceeding £325,000 is left to a charity or a community amateur sports club.
When assessing the estate’s value, you need to meticulously calculate the assets at the time of the individual’s demise, encompassing cash, investments, properties, businesses, vehicles, life insurance payouts, and liabilities.
If inheritance tax is applicable, the estate theoretically incurs a 40% tax rate on any amount surpassing the £325,000 threshold upon death (or a 36% rate if at least 10% of the remaining value after deductions is bequeathed to a charity through your will).
The term ‘theoretically’ is employed because, contingent on specific circumstances, there exist strategies to elevate this £325,000 tax-free allowance to an enhanced threshold of £500,000 or more. The intricacies of these methods are elucidated in the subsequent two insights.
3. Passing on your home can BOOST your allowance to £500,000 (if you leave it to your children or grandchildren)
In the current tax year, 2023/24, no inheritance tax is due on the first £325,000 of any estate, with 40% normally being charged on any amount above that.
However, the amount that’s taxable will be lowered for anyone who leaves their home to their ‘direct descendants’. This includes your children (whether biological, adopted, foster or step) or grandchildren, but not, for example, nieces and nephews.
This is because you will then have two tax-free allowances:
£325,000 – this is the basic inheritance tax allowance that everyone gets, which still applies.
£175,000 – since 2017, everyone has also been able to take advantage of something called the ‘residence nil-rate band’, commonly known as the ‘main residence’ band. This is an additional allowance you’ll receive ON TOP of the existing £325,000 inheritance tax allowance if you pass on your main residence to your children (including adopted, foster and stepchildren) or grandchildren.
This means inheritance tax might not be due on the first £500,000 of your estate (£325,000 + £175,000), depending on who you leave your home to. However:
- The £175,000 main residence allowance only applies if your estate is worth less than £2 million. (On estates worth £2 million or more, the main residence allowance will decrease by £1 for every £2 above £2 million that the deceased’s estate is worth.)
- Your home won’t qualify for the £175,000 main residence allowance if it’s in a ‘discretionary will trust’, even if the beneficiaries of the trust are your children or grandchildren.
- If your home’s not worth £175,000 (or £350,000 if two spouses’ allowances are combined – you can’t combine allowances if you’re not married or in a civil partnership), you can’t use the main residence allowance to offset tax against other assets. So, technically it’s an allowance of ‘up to’ £175,000.
4. Any unused inheritance tax allowance passes to your spouse
As previously mentioned, assets bequeathed to a spouse or civil partner enjoy immunity from inheritance tax. However, the advantages extend further for married couples.
In addition to the individual inheritance tax allowance, there is a noteworthy perk: the inheritance tax allowance for your spouse increases by the percentage of your own allowance that remains unused. This dynamic interaction implies that as a couple, you can collectively leave a substantial £1 million tax-free. This amalgamation includes two individual £325,000 tax-free allowances and two main residence allowances of £175,000 each. Hence, the cumulative impact of these allowances enhances the financial flexibility for married couples in navigating the inheritance tax landscape.
5. Still likely to have to pay inheritance tax? There are ways to legally reduce the bill
For those in the minority facing the prospect of inheritance tax on their estate, there are strategic approaches to trim down the bill. Notably, gifts or money bestowed during your lifetime can impact the eventual inheritance tax liability, necessitating a familiarity with the associated regulations.
In straightforward terms, gifts made more than seven years before your death are exempt from inheritance tax, unless they are part of a trust. However, gifts within the seven years leading up to your death will factor into your £325,000 inheritance tax allowance. Even if the cumulative value of gifts within this period is less than £325,000, they can influence the inheritance tax levied on the remaining estate.
If the gifts exceed £325,000 within the seven years preceding your death, inheritance tax on the surplus (in addition to any tax on the remaining estate) will be imposed on a sliding scale, reaching a maximum rate of 40%.
Everyone has the freedom to make certain exempt gifts each year:
- Tax-free gifts: You can give away up to £3,000 annually, and any unused portion can be carried forward to the next tax year.
- Gifts to charities: Donations to charities have no inheritance tax limit, and if the donation is 10% or more of your estate, it reduces other inheritance tax to 36%.
- £250 gifts to individuals: Gifts of up to £250 per person annually are exempt from inheritance tax.
- Gifts from income: Regularly giving money from your income, as long as it doesn’t impact your lifestyle, is tax-free.
- Wedding gifts: Tax-free gifts for weddings with limits: £5,000 for a child, £2,500 for a grandchild, and £1,000 for anyone else. Can be combined with the £3,000 annual exemption but not with the £250 small gift allowance.
- Funding living costs: Contributing to a loved one’s living costs or tuition fees can be given tax-free from your regular income.
Inheritance tax becomes applicable on gifts made within seven years of death if they exceed the tax-free threshold of £325,000 and are not considered tax-free gifts. Even gifts below the threshold within this seven-year period diminish the estate’s overall £325,000 tax-free allowance.
What constitutes a gift?
When making a gift to mitigate inheritance tax, it’s crucial that the gesture is a bona fide, unconditional offering, devoid of any expectation of personal gain. A genuine gift is one bestowed upon someone without any strings attached, free from agreements or reciprocal arrangements.
The primary residence often constitutes the most substantial asset for many individuals. However, attempting to gift your home to your children may not yield the desired tax benefits if you continue residing in it without paying a market rent to the recipients.
While various gifts, as outlined earlier, can effectively reduce your inheritance tax liability, it’s imperative to note that any gifts given with conditions (excluding wedding gifts) and with the expectation of receiving something in return may not yield the intended tax advantages.
Caution is advised to avoid potential pitfalls in the effectiveness of these strategies.
If you are thinking about making significant lifetime gifts, it may be worth considering life insurance as a safeguard against potential inheritance tax liabilities. It’s also important to be aware that many gifts into trusts are now subject to inheritance tax even when made during your lifetime. However, navigating the intricacies of this area requires specialised advice, emphasising the importance of consulting with experts in estate planning and tax matters.
The landscape of taxation and inheritance is complex, and professional guidance can help ensure that your financial decisions align with your goals and comply with relevant regulations. If you require advice on your tax and inheritance planning, please contact a member of the CB Reid team.