Site Logo
Site Logo

Inheritance Tax

8 Mar, 2022

Inheritance tax – we've all heard of it, but it’s probably a stretch to say that all of us completely understand it. And while it may be tempting to leave what's left after you die to your next of kin, you could end up saddling your loved ones with a hefty tax bill that takes chunks off of what you’ve left behind. Working out how to avoid this, however, can be pretty daunting. That’s where we come in. We’ve put together a guide on what Inheritance Tax is, how it works, and some simple steps you can take to avoid it.

What is Inheritance Tax?

Inheritance Tax is a tax that some people have to pay to the UK government if the value of their belongings, property and money (known collectively as their ‘estate’) exceeds a certain threshold when they pass away. This threshold is called the ‘nil-rate band’ and any amount above this is liable for Inheritance Tax.

How does Inheritance Tax work?

Inheritance Tax is payable when the total value of an estate exceeds the nil-rate threshold, which is currently £325,000.

There are several exemptions to this rule, however, so you may find that you don’t actually have to pay any Inheritance Tax at all. In fact, only 1 in 20 estates in the UK end up paying, according to data from HMRC.

Inheritance Tax is usually not applied if any of the following criteria are met:

  • The total value of the estate is below the threshold of £325,000

  • You leave everything above the threshold to a spouse or civil partner

  • You leave everything above the threshold to a charity

So, even if the total value of your estate is above the threshold – let's say, £500,000 – if you choose to leave everything above £325,000 to your spouse, you won't have to pay a single penny of Inheritance Tax.

Note that the nil-rate threshold increases to £500,000 if you leave your property to your children (including adopted, foster or stepchildren) or grandchildren, so if you’re feeling generous, you could shield even more of your assets from the taxman by gifting the kids your home.

Plus, if you’re married or in a civil partnership and your estate is worth less than £325,000, any of the threshold which your assets didn’t use up can be added to your partner’s threshold when you pass away.

How much is Inheritance Tax?

Inheritance Tax = 40% of the amount of your estate that is above £325,000.

Inheritance Tax is charged at 40% of the amount which exceeds the nil-rate threshold of £325,000. However, it can be reduced to 36% if you leave 10% or more of the net value of your estate to a charitable organisation, such as an animal shelter or an amateur sports club. Let’s explain how this works in practice.

For example, if the total value of your estate is £500,000, Inheritance Tax of 40% would be applied to the £175,000 left above the nil-rate threshold (£500,000 - £325,000 = £175,000). This would amount to an Inheritance Tax bill of £70,000 (40% of £175,000 = £70,000).

If you decide to leave 10% of the ‘net value’ of that same estate – the amount which exceeds the nil-rate threshold - to your local animal shelter, you would be eligible for the reduced rate of 36%. This would amount to an Inheritance Tax bill of £56,700 (£175,000 - £17,500 = £157,500, 36% of £157,500 = £56,700).

Who pays Inheritance Tax?

Since Inheritance Tax is only payable once you’ve passed away, it usually falls to the executor of your will to arrange paying the Tax. If you don’t have a will in place when you die, it’s the administrator of the estate who has this responsibility.

Most of the time, Inheritance Tax is paid through the Direct Payment Scheme (DPS). If you have money in a bank or building society account when you die, whoever’s in charge of your estate can ask for some (or all) of the amount due to be paid to be transferred directly from the account to the government.

Inheritance Tax on gifts given in the 7 years leading up to your death must be paid by the recipient (but more on this later).

When do you have to pay Inheritance Tax?

There’s a cut-off point by which Inheritance Tax will need to be paid – the end of the 6th month after you pass away. If the payment isn’t made in full by this point, the government will start charging interest. Sometimes Inheritance Tax is paid in instalments over a period of time, but the government will continue to charge interest on the outstanding amount until the debt is cleared. As of March 2022, this interest rate is 3%.

Which assets are exempt from Inheritance Tax?

There are some assets and property which may be exempt from Inheritance Tax, such as wedding presents and farmland, and these are known as ‘gifts’ or ‘potentially exempt transfers (PETs)’.

These can include any of the following:

  • Money

  • Household and personal items

  • A house, land or building(s)

  • Stocks and shares listed on the London Stock Exchange

  • Unlisted shares you held for less than 2 years before your death

However, any gifts given in the 7 years leading up to your death could be liable for Inheritance Tax. This is known as the ‘7 Year Rule’.

Check out chartered financial planner Justin King’s helpful explanation of gifts and exemptions.

What is the 7 Year Rule?

PETs are treated as tax-free when you make them, and provided you survive for seven years after making the gift, no inheritance tax is payable. If tax does become due on a PET, the person who received the PET will be asked to pay the tax.

Chris Broome photographChris Broome photograph
Chris BroomeChartered financial planner

The good news is that there’s no Inheritance Tax to pay on any gifts given to spouses or civil partners at any point during your lifetime (lucky folks!).

But gifts given to anyone else in the 7 years preceding your death are liable for Inheritance Tax, the rate of which tapers depending on their value and when they were given. This is referred to as the 7 Year Rule.

Check out the table below to see how Inheritance Tax is applied to a gift if you pass away within 7 years of granting it. Remember that it’s the recipient of the gift who’ll have to foot the bill.

Inheritance Tax taper rate

How to minimise/avoid paying Inheritance Tax

Fortunately, there are a number of ways that you can minimise - or altogether avoid - paying Inheritance Tax by making some changes to your finances. We’ve rounded up 5 of the easiest ways you can shield money from the taxman when you’re not around anymore.

1. Make sure you have a will

This is an extremely important step if you want to make sure your loved ones aren’t footed with any more Inheritance Tax than necessary. Set up a will so that your assets are distributed the way you want them to, otherwise they’ll be allocated according to the rules of ‘intestacy’ – an old-fashioned system that doesn’t really account for the complexity of modern family dynamics – and you could end up leaving a great deal to someone you wouldn’t have liked to leave anything to at all. Citizens Advice has a detailed breakdown of intestacy rules. They’re non-negotiable, so without a will, your estate must be allocated in this way. This could expose certain assets and make them liable to Inheritance Tax that could’ve otherwise been avoided. Plus, having a will which stipulates exactly who gets what could save your family from any nasty disagreements when you’re not around to mediate. The government website has a useful intestacy calculator which can show you what will happen to your estate if you die without a will.

2. Keep your estate below the nil-rate threshold

The most effective way of reducing your estate is by giving the money away, but then it isn’t yours to use at a later date if needed.

Andrew Neligan photographAndrew Neligan photograph
Andrew NeliganChartered financial planner

Another crucial step for avoiding Inheritance Tax. As long as you keep the total value of your estate below £325,000 (or £500,000 if you’re leaving your property to kids or grandkids), no one will have to pay any Inheritance Tax at all. So what are your options? You can make use of your annual gifting allowance, distributing your assets around family and friends while you can so that they’re not counted as part of your estate. Or you can put assets into a trust - also exempt from Inheritance Tax – which is a popular option for those wanting to leave something to younger family members to receive once they turn 18. Alternatively, you can downsize for a smaller (and less expensive) property, or just have some well-earned fun by spending any of your savings (holiday, anyone?) so that they won’t contribute towards the value of your estate. The important thing to realise, however, is that you can’t have your cake and eat it – you’re going to have to relinquish ownership of some assets.

3. Move your savings into your Pension

It’s often overlooked that Pensions are exempt from Inheritance Tax, so if you’re looking for another way of reducing the size of your estate, consider putting any money you have in a savings account – such as an ISA – into your Pension instead. Remember that you can put up to either £40,000 or 100% of your income into your Pension fund each year (whichever is the lowest), so if you start early, you could tuck away a sizeable amount so that it won’t be liable for Inheritance Tax. Just remember that you’ll need to name a beneficiary for your Pension fund to receive it when you’re gone. It’s usually quite easy though, and you can start by sending a letter directly to your Pension provider.

4. Leave some money to charity

You can reduce the amount of Inheritance Tax on your estate to 36% (rather than the standard 40%) if you leave some assets/money to a charitable organisation. This could be anything from the local 5-a-side club your grandkids play with on weekends to the big charities whose adverts are always on daytime TV – it's up to you. All you have to do is make sure that the amount you leave is at least 10% of the net value of your estate (that’s anything that exceeds the nil-rate threshold).

5. Take out life insurance

If you want to do your family a favour for when you’re not around anymore, you can take out a life insurance policy which will cover the Inheritance Tax bill for them – just make sure you put it into a trust so that the policy isn’t counted as part of your estate.

Need advice on how to plan for Inheritance Tax?

Inheritance Tax is a tricky subject, and there's no shame in being confused or needing help to get all your ducks in a row. Why not contact one of our professional financial advisers directly?

Want to find out 3 ways you can get professional advisers to help manage your portfolio and reduce your Inheritance Tax liability? Check out our guide below.