What Is Inheritance Tax?

INTRODUCTION

Inheritance Tax (or IHT) is central to the estate planning process.

However, this area can often be daunting for many of our clients, given its perceived complexity and misconceptions.

This article demystifies the subject of Inheritance Tax (IHT) by defining it clearly. We'll also break down the IHT rates, lay out some of the exemptions, and provide some clarity on areas where IHT may have an impact on your Estate and Beneficiaries.

WHAT IS INHERITANCE TAX ?

“In this world, nothing can be said to be certain except death and taxes.”

This famous quote by Benjamin Franklin rings so true, particularly when it comes to Inheritance Tax.

Inheritance Tax, commonly known as "IHT," is a tax on your Estate after you pass away.

Your Estate includes money, property, and other possessions and assets.

WHAT ARE INHERITANCE TAX RATES?

Standard Inheritance Tax Rate:

The standard inheritance tax rate is 40%; it is only charged on the part of your Estate that exceeds the nil-rate band (or threshold).

Reduced Rate:

If you bequeath 10% or more of the 'net value' of your Estate to a charity in your Will, the IHT might qualify for a reduction to 36% on certain assets.

ILLUSTRATION:

• Value of Estate: £500,000

• IHT Nil-Rate Band (Threshold): £325,000

• Taxable Amount: £175,000 (which is £500,000 minus £325,000)

• IHT Due at Standard Rate: 40% of £175,000 = £70,000

NOTES:

This illustration assumes that no exemptions or reliefs apply and no gifts have been made to charities.

You should also consider the 'residence nil rate band' (RNRB), which might increase your threshold if you leave your home to your next of kin.

YOU ARE EXEMPT FROM PAYING INHERITANCE TAX IF:

• Below Threshold: Your Estate's value is below the £325,000 threshold.

• Above Threshold: You pass on everything above the £325,000 threshold to your spouse, civil partner, a charity, or a community amateur sports club.

IMPORTANT EXCEPTION: If your spouse or civil partner is not UK-domiciled, there might be limits to the amount you can transfer to them without incurring IHT. Transfers above this limit could be subject to taxation.

NOTE: Even if your Estate's value falls below the threshold, you must still report its value to HMRC.

YOU CAN INCREASE YOUR THRESHOLD TO £500,000 IF:

You leave your home to your children or grandchildren.

NOTE: "Children" includes adopted, foster, or stepchildren.

WHAT ARE THE RULES ABOUT UNUSED THRESHOLDS?

If you're in a civil partnership or married, and your Estate's value is under your threshold, any unused threshold can be added to your partner's threshold upon your death.

ILLUSTRATION:

Imagine Mr Jones has an Estate worth £250,000. Given that the threshold is £325,000, he hasn't used £75,000 of his threshold. When Mr Jones passes away, this unused threshold can be transferred to his partner, Mrs Jones.

If Mrs Jones originally had a threshold of £325,000 with the transferred amount, her new threshold becomes £400,000 (£325,000 original + £75,000 transferred). In cases where both partners have not used their thresholds at all, the combined threshold for the surviving partner can go up to £650,000.

With other possible additions like the residence nil-rate band, the effective threshold could be as much as £1 million for Mrs Jones.  

WHAT EXEMPTIONS AND RELIEFS EXIST?

Remember that some 'gifts' you grant while alive may be taxable after you pass away. Various reliefs and exemptions can reduce the amount of IHT due.

HMRC stipulates: "Depending on when you gifted it, 'taper relief' might reduce the Inheritance Tax charged on the gift to less than 40%."

Additionally, business relief "might allow some assets to be passed on either free of inheritance tax or with a reduced bill" (HMRC).

 1. Taper Relief and Potentially Exempt Transfers (PETS)

• Potentially Exempt Transfers (PETS): These are gifts you make during your lifetime that aren't immediately exempt from IHT. However, for the gift to be entirely exempt from IHT, you must survive seven years after making it. If you die within seven years, the gift may become liable for IHT.

• Taper Relief: If a gift does become liable for IHT because you die within seven years of making it, taper relief can reduce the amount of tax due. Taper relief operations on a sliding scale, whereby the longer you survive after making the gift, the less IHT is due if the gift becomes taxable.

Here's the breakdown:

• 3-4 years after the gift: 32% tax (instead of 40%)
• 4-5 years: 24% tax
• 5-6 years: 16% tax
• 6-7 years: 8% tax
• > 7 years: No IHT due on the gift.

2. Business Relief:

Business relief allows certain business assets to be passed on, either free of IHT or with a reduced tax bill, either during one's lifetime or as part of a Will.

Depending on the type of assets, the business relief can be either 50% or 100%.

• Assets that might qualify for 50% relief include shares controlling more than 50% of the voting rights in a listed company.
• Assets that might qualify for 100% relief include a business or interest in a business.

It's essential to remember that these reliefs and exemptions have specific conditions and criteria attached to them. 

ADDITIONAL POINTS TO CONSIDER

TRUSTS

Trusts can be an essential tool in estate planning, providing the means to manage and distribute your assets according to specific criteria.

There are several types of Trusts, including Discretionary Trusts, Interest in Possession Trusts, and Accumulation Trusts. Each has its own set of rules and conditions.

For more detailed information on Trusts, please consult our extensive library of FAQs.

NOTES:

The nil-rate band has remained at £325,000 since April 2009, but we always advise you to check for any updates or changes.

This article was last updated in November 2023. For those relying on this information for estate planning or other purposes, always consult a tax professional or check the latest guidelines from HMRC, as tax rules and allowances may change over time.

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