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How is Inheritance Tax calculated in UK

how is inheritance tax calculated in uk
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Inheritance Tax (IHT) is a tax paid on the Estate (the property, money, and possessions) of someone who has died. It is currently set at 40% with a complicated system of exemptions, reliefs and Nil Rate Bands in place.

In its simplest form, Inheritance Tax in the UK is calculated by deducting our personal IHT Allowance of £325,000* from the total value of our Estate, with the resulting number being subject to Inheritance Tax at 40% upon our death.

*IHT Allowance correct as of March 2022

Read on to find out more about Inheritance Tax, the Inheritance threshold and Tax-Free Allowances…

What is Inheritance Tax?

Inheritance Tax (IHT) is a tax that is due upon your death, levied against your Estate, which is defined as your property, savings and other assets after any debts and funeral expenses have been deducted.

How does inheritance tax work?

We each have an Inheritance Tax Allowance of £325,000: any assets above this threshold are normally subject to Inheritance Tax at 40% upon our death.

If you have not used all or part of your Inheritance Tax Allowance, any balance can be passed on to your spouse or civil partner when you die. This means a couple, therefore, have a total Inheritance Tax Allowance of £650,000.

An additional allowance was introduced in 2017, call the Residence Nil Rate Band Allowance (RNRB), which can help to reduce your Inheritance Tax bill.

The RNRB allows you to claim an additional £175,000 of tax-free allowance, if you give away your home to your children (including adopted, foster or stepchildren) or grandchildren.

This additional allowance means that the Inheritance Tax threshold for a single person rises to £500,000, while it can increase to £1,000,000 for a couple.

However, these additional tax-free allowances come with many caveats and strings attached, and there are pros and cons to consider before using them, as they can affect how much Inheritance Tax is due and increase your potential Inheritance Tax bill.

The RNRB cannot be used to reduce the Inheritance Tax bill for loved ones outside of your immediate bloodline. So, if you have a godchild or a special niece or nephew you want to bequeath your Estate to, it will be subject to the standard Inheritance Tax rate. This can be even more frustrating if you do not have any children of your own, as this benefit is not then available to even consider using to reduce your Inheritance Tax liability.

We would always recommend that you speak to an Estate Planning expert for Inheritance Tax advice before committing to use this extra Inheritance Tax Allowance.

The Inheritance tax threshold is currently set out as follows…

There is normally no Inheritance Tax to pay if either:

  • The value of your Estate is below the £325,000 threshold
  • You leave everything above the £325,000 threshold to your spouse, civil partner, a charity, or a political party.

Even if the Estate value is below the threshold, you will still need to report it to HMRC through Probate.

How to calculate the Inheritance Tax

The standard Inheritance Tax rate is 40%. It is only charged on the part of your Estate that is above the tax-free threshold, the amount a recipient can keep before he or she pays Inheritance Tax.

  1. Work out the market value of all the Estate’s assets and add them up. This exercise will give you the Estate’s ‘gross value’.
  2. Deduct any debts, such as unpaid mortgages, overdrafts, and loans, to find out the Estate’s net value. You will also need to deduct any tax relief you get on business assets and agricultural assets.
  3. Deduct the value of tax-exempt assets. This includes tax-free gifts, anything left to spouses, charities or other tax-exempt beneficiaries and anything gifted seven years or more before the deceased passed away.
  4. Deduct the current and available Tax-Free Allowances from the answer in step 3. You will have to pay 40% tax on anything that’s leftover.

Example

Your Estate is worth £700,000 and your tax-free threshold is £325,000 + £175,000 of Residential Nil Rate Band Allowance = £500,000. The Inheritance Tax charged will be 40% of £200,000 (£700,000 minus £500,000) = £80,000 of Inheritance Tax to be paid.

The Estate can pay Inheritance Tax at a reduced rate of 36% if you leave 10% or more of your Estate to charity in your Will. If you leave money to your favourite political party, this can also help reduce the Inheritance Tax rate, although we don’t seem to get many requests to do that!

Who has to pay Inheritance Tax?

Who pays Inheritance Tax depends upon the relationship the beneficiaries had to the deceased owner of the Estate.

The deceased person’s husband, wife or civil partner would qualify as an exempt Beneficiary, as would any registered charities or political parties that the deceased has left a gift to in their Will.

Anyone else will be responsible for settling any Inheritance Tax due after Probate has been completed.

Why do I have to pay Inheritance Tax?

Inheritance Tax is one of the ways the Government raises income for the Treasury to utilise to fund public services.

It seems that every year HMRC breaks new records with their Inheritance Tax receipts. The last full tax year (2020/21) is no exception, with £5.9 billion being paid a new record.

And with receipts for the 2021/22 tax year already ahead of the previous year’s trend by £0.6bn, another bumper year is anticipated.

However, Inheritance Tax is largely a voluntary tax, which can be legitimately mitigated, meaning you no longer have to worry about losing 40% of your wealth on death.

Can I reduce my Inheritance Tax bill?

Yes, there are many steps you can take to reduce or mitigate your Inheritance Tax liability and protect your legacy for your loved ones and beneficiaries. Here are some steps you can take. You should seek professional advice to understand which one, or combination of steps, can minimise your liability.

Ensure you have a valid Will

Having a valid Will is the critical starting point to Estate Planning. Making a Will is one of the most important things you can do to ensure your Estate goes to who you want and that your wishes are carried out.

If you do not have one, you need to make one. If you have one, it must be reviewed to ensure it is up to date and valid.

Even if your Will is valid, you might need to act. For example, you might need to revisit your Will to benefit from the new Residence Nil-Rate Band tax relief, which is only available if assets are left directly to descendants. Many Wills written prior to this new legislation coming into effect hold assets in Trust and you could lose out if your Will is not updated.

While a basic Will or a Will from an Online Will Writing Service is ideal for making sure your legacy goes to the people you choose, it is insufficient if your goal is true Estate Planning.

Many people set up Mirror Wills with their spouse or civil partner, which means that they leave their Estate to the other in the event of their death. However, it might make more sense to make a Will that transfers some assets to children or grandchildren after the death of the first spouse. It all depends on your circumstances and you should seek professional advice and guidance that is tailored to your unique requirements.

If you want to put Estate Planning in place, we strongly recommend you take professional advice to create a Will that makes sure your wishes are met and that they are crafted to be as tax-efficient as possible.

Insure against your Inheritance Tax liability

Life Insurance Policies are often underused, overlooked and yet remarkably simple and cost-effective solutions to an Inheritance Tax problem.

Let us assume there is an Inheritance Tax liability on your death of £100,000, you could simply choose to take out a life insurance policy for £100,000. As long as it is the right type of policy, paying into the right type of Trust, it will provide the money to your beneficiaries on your death so they can use the life insurance proceeds for paying Inheritance Tax due and don’t have to find the money to pay the tax bill themselves.

Depending on your age and health, we often find that Clients pay far less in life insurance premiums than they ever do in Inheritance Tax.

Give your Assets away

You could choose to give some of your wealth away before death occurs. However, there are some important rules to be aware of.

First is the Seven-Year Rule which says that if you give away some of your wealth, then in order for that wealth to be outside of your Estate for Inheritance Tax purposes, you need to survive for seven years after the gift has been made.

The second is the Gift with Reservation of Benefit Rule, which says it must be a true gift. If you give some of your assets away, for example, you sign your house over to your children before you die, then you cannot reserve some kind of benefit or use of that house.

You would have to pay your children the full market rent value to continue living in the property and you cannot receive any of that rental back as a gift from your children. If you do, then the seven-year clock doesn’t even begin to tick and the value of your property or any money you have received will be counted back into your Estate for the purposes of Probate upon your death.

While giving away your wealth might seem an attractive solution to reduce an Inheritance Tax liability, it is vital to do this in a safe and secure way, such as using a Trust. Imagine giving it to your married daughter and then she goes through a divorce. The wealth she has received now forms part of her assets and can be taken into consideration when the assets are divided as part of the divorce process.

Inheritance Tax Investments

Investments can also be an excellent way to solve an Inheritance Tax problem.

The Government have a range of investments that they exempt from Inheritance Tax that you can choose to use.

These types of investments are not available from your high street banks or building societies, these are true investments into the market, so it’s no good just simply saying if a particular investment works for Inheritance Tax then you should put all of your money into it.

It is important that you take specialist investment advice from a specialist Financial Adviser. Whether that’s us or somebody else, it’s critical we make sure that any investment strategy meets ALL your investment needs, including what risk are you happy to take with your money, do you need access to capital, income or both, what growth are you expecting?

A specialist Financial Planner should be able to meet all those needs whilst also finding you an investment strategy that will be able to give you the Inheritance Tax exemption, saving you 40% tax at the same time.

Spend the kid’s Inheritance!

If you have an Inheritance Tax problem and you are happy that you have more money than you need to look after yourself for the rest of your life, you may want to start considering spending some of that wealth now, on things that you enjoy.

Whether that is booking another world cruise, some holiday of a lifetime or anything else that helps you to spend the money. Think of it like there is a 40% sale on permanently! Every time you spend £10,000 of your money, that’s £4,000 that won’t be going to the Inland Revenue.

If you have done everything in life you want to do, but still have more money than you need, then why not consider spending your wealth on whoever your beneficiaries are now.

Why do we wait to pass the wealth to the next generation when we die? We don’t get to see the amazing effect we’ve had on our loved ones with this wealth and for those of us left behind, it’s bittersweet because yes, we’ve received the family wealth but we’ve also lost somebody we love at the same time.

But if we are going to give some of that wealth away before we die, it comes back to the earlier point about doing it safely and the best way to do that is through our Protective Family Trusts.

To find out more about reducing your inheritance tax bill, read this How to cut your Inheritance Tax

FAQs

How much money can you receive as a gift?

Each person has an annual tax-free gift allowance of £3,000, often referred to as your annual exemption. With your annual gift allowance, you can give away assets or money up to a total of £3,000 without them being added to the value of your Estate. Once you’ve exceeded this allowance, the gifts you give may be subject to Inheritance Tax in the event of your death.

You are allowed to roll over your tax-free gift allowance to the following year if you do not use it in the current year. You’re only allowed to do this once, so you couldn’t roll any allowance you haven’t used over for a second year.

Provided both live permanently in the UK, Spouses and Civil Partners can gift as much money as they like to each other and neither will have to pay tax.

Do I need to declare a gift as income?

You will not have to pay income tax on gifts, although you may have to pay income tax on any interest your gift earns. However, you may be liable for Inheritance Tax payments when the person who made the gift dies.

This isn’t a given. You may be able to avoid paying inheritance tax. However, to do this, it’s important to make sure any gifts you receive are in line with HMRC’s rules.

What does HMRC count as a gift?

HMRC classes anything you receive that has value as a gift.

This includes:

  • Money
  • A car, jewellery or other possessions
  • Property
  • A loss in value. So, if your parents own a house that has a market value of £250,000 and they sell it to you for £200,000, the £50,000 they lose on the sale counts as a gift.

What is the 7-year rule in Inheritance Tax?

The Seven-Year Rule says that if you give away some of your wealth, then in order for that wealth to be outside of your Estate for Inheritance Tax purposes, you need to survive for seven years after the gift has been made.

In Summary

Inheritance Tax Planning is about putting proactive planning in place to make sure your Estate is held and passed down to your beneficiaries in the most tax-efficient way possible. Family wealth is often subject to Inheritance Tax as it passes down each generation, eroding that wealth for you and your loved ones over time.  How much tax they will pay will depend very much on what your Estate is worth when you pass away, and the level of proactive Estate Planning you have put in place.

Talk to Redwood Financial for Advice

At Redwood, we bring our expertise in both Estate Planning and Financial Planning, to tackle your Inheritance Tax liability on both fronts. Bringing the two disciplines together, means our Clients have a more comprehensive understanding of all the different ways you can legitimately mitigate your Inheritance Tax bill and save you and your loved ones 40%.

FREE Wills & Trusts Webinars

To find out more we always recommend that you start by attending one of our FREE 40 minutes Wills & Trusts Estate Planning Webinars. This will give you a good insight into what is involved before you even embark on your Inheritance Tax Planning journey.

Jasmine Lambert Chartered Financial Planner
Jasmine Lambert

Jasmine is the Managing Director and a Chartered Senior Financial Planner at Redwood Financial. She helps clients manage and grow their wealth and protect their estate. Jasmine also provides expert advice in our FREE Redwood Webinars, where you can learn more about Wills, Trusts and Estate Planning.

Redwood Financial is one of the south’s leading Investments, Pensions, Wills, Trusts & Estate Planning providers and we are dedicated to helping families to grow, protect and enjoy their wealth. With our unrivalled knowledge of Estate Planning, Lasting Powers of Attorney, Probate, Pensions, Savings & Investments, we can advise on any situation.
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