Inheritance tax (IHT) and how much money you can leave to your heirs after your death is one of those political hot potatoes that divides critics and advocates alike. However, no matter what you think about it, inheritance tax planning is something most of us should do.
Understanding inheritance tax and planning to minimise the amount of tax due on your estate can result in hundreds of thousands of pounds extra going into the pockets of your beneficiaries.
Inheritance tax planning is simple to do. From making a will to chipping away at the value of your estate through gifts to friends and family can significantly – and legally – reduce the amount of inheritance tax your estate ends up paying.
What is inheritance tax?
Simply put, inheritance tax is a flat-rate tax that is levied on the combined value of all the assets you own at the time of your death, minus any debts you may owe.
Many people question the need for this tax at all. But its aim is to prevent the generational concentration of wealth – the very rich continuing to keep all their assets – by ensuring a significant chunk is given to the government as a tax which it can then redistribute through government services.
Inheritance tax is set at 40%, which is levied on the value of all assets over a certain threshold. Anything below this threshold is known as a tax-free allowance. Broadly speaking you won’t pay any tax on your estate up to £325,000 and then 40% on anything above that threshold.
That’s why inheritance tax planning is important.
What is inheritance tax planning?
There are lots of ways to reduce the amount of inheritance tax due on your estate. Taking time to assess the value of your assets and using financial mechanisms such as trusts can save thousands going to the taxman. For example, you can put your life insurance pay out into a trust and therefore make it exempt from inheritance tax.
Learn how to make a will – from dividing your estate to choosing an executor – with our guide Making a will: how to make a will.
What are the inheritance tax planning allowances?
When you die, the executor of your will must inform the Probate Office and HRMC of the value of your estate. This will include anything that can be sold, including jewellery, furniture, cars, furniture, art, electricals and so on. In short, anything of value. It will also include larger value items such as property, stocks and shares, savings, pensions and life insurance payouts. That’s all added up, and any debts such as mortgages and loans subtracted to give a total value of your estate.
Tax is then due at 40% on the value above £325,000. The tax is due even if the assets aren’t liquid, such as cash or savings, which means your beneficiaries may have to sell assets such as property to pay the tax bill.
It doesn’t matter how you’ve divided up your assets between your beneficiaries. Even if each were to receive a portion of your estate valued less than the £325,000 tax threshold, it’s the total value of the estate that is used to work out how much tax is due.
Unmarried Mr Smith dies with a total estate worth £600,000, including savings and a £250,000 life insurance payout that was not paid into a trust. He did not own his own home. His three children think they will inherit £200,000 each, but the reality is different. The first £325,000 is tax-free, while the remaining £275,000 is taxed at 40% resulting in a tax bill of £110,000. This gives a total value after inheritance tax of £490,000 – meaning each child receives £163,333 after tax.
However, there are some exceptions – such as being married or owning a family residence – that are worth knowing for inheritance tax planning purposes as they can dramatically reduce the inheritance tax bill.
Inheritance tax planning and marriage
If you are married when you die, your surviving spouse will inherit all your assets tax-free (unless you willed your assets to not be awarded to your spouse). They will also inherit your tax-free allowance as well. Adding both tax-free allowances together gives a total inheritance tax allowance of £650,000. This means when your spouse subsequently dies, the first £650,000 of the estate is exempt from inheritance tax.
Inheritance tax planning if you’re not married
If you’re not married but survived by a partner, inheritance tax becomes more complicated. Your surviving partner does not automatically inherit your assets and instead, they are subject to the £325,000 tax threshold. Unless you explicitly leave your assets to your partner in your will, your other relatives may have a stronger claim on your assets – including forcing the sale of your shared home. However, there is a ‘right to survivorship’ that can protect a surviving partner but the best advice is to make a will.
How you own property together makes a big difference. If you’re joint tenants (co-owning the property in its entirety) then your half should be inherited by your surviving partner. If you are tenants-in-common the situation is different, as you both own a specific and different part of the property. In this case, unless you have willed your portion to your partner, your relatives will have a greater claim on your part and can force the property to be sold to release the assets.
Inheritance tax planning and main residence allowance
If you own your family home and it is inherited by your direct descendants – defined as a child, step-child or grandchild – it benefits from a newly introduced main residence allowance. Introduced in the 2017/18 tax year, it aims to make passing on a family home worth up to £1m tax-free by 2020.
It works by adding an extra £150,000 allowance (for 2018/19) that can be added to the £325,000 tax-free allowance and applies that to the value of the family home. If you’re single and never married but have children, that means you can pass the value of your home onto your direct descendants up to a value of £475,000.
Remember, if you are married then both your tax-free and main residence allows get passed over to your surviving spouse. When your spouse subsequently dies, both tax-free allowances of £325,000 and both main residence allowances of £150,000 are added together. This gives a total tax-free allowance of £950,000 that can be applied to the main residence. It means a family home can be passed onto your direct descendants up to £950,000 in tax-year 2018/19 tax-free.
The main residence tax allowance is set to increase by a further £25,000 in the tax year 2019/20 – giving a combined total tax-free allowance of £1m.
Inheritance tax planning for properties worth more than £1m
If your main residence is worth more than £1m, then inheritance tax kicks back in. There is no inheritance tax-free allowance on the value of a property between £1m and £2m. In all cases, your estate would have to pay 40% tax – equal to £400,000 on a £2m home.
For homes worth more than £2m tax relief actually goes into reverse. For every £2 above the £2m threshold, £1 is deducted from the tax allowance that is applied to the first £1m of the property value. That means if your home is worth £2.7m you won’t attract any main residence tax relief.
Looking to put money away for your grandchildren? Learn how our Saving for grandchildren – where to start guide can help you discover how to get the best return on your investment.
Five simple inheritance tax planning steps you can take to pay less tax
Inheritance tax planning is worth enlisting the help of an independent financial advisor. Expert advice now can save thousands in needless tax that you can legitimately and legally avoid. Below are five things you can start doing now to reduce your tax bill and increase the amount value that you pass onto your beneficiaries:
Make a will – This is especially true if you have a partner but are not married and you have children. If you die without a will there is a set pecking order in terms of how your estate gets divided up, and that can see your surviving partner being disadvantaged.
Give money away – Chip away at the value of your estate by giving away money to relatives before you die. The lower the overall value of your estate, the less tax you’ll pay above the £325,000 tax threshold. You can gift £3,000 each year tax-free to relatives, and if you don’t use it one year you can carry forward the allowance to the next year, giving £6,000 tax-free. Cash gifts of £250 to friends are also ignored. If your child or grandchild is getting married, you can also give £5,000 to a child or £2,500 to a grandchild shortly before or on the day of their wedding tax-free.
Set up a trust – Anything that you put into a trust for a child that they can’t access directly until their 18th birthday is excluded from inheritance tax. You need to get independent financial advice, as trusts can attract different kinds of tax liabilities such as Capital Gains and Income Tax. If the trust is set up in your will and effectively comes into existence at the time of your death it is exempt from Capital Gains Tax.
Pay life insurance into a trust – Make sure that when you take out life insurance any payouts on death are paid into a trust. The prevents it from being added to the value of your estate – trusts are exempt – and means your beneficiaries will get the full benefit of your life insurance payout.
Give to charity – There are benefits to leaving money to charity. Anything you leave is tax-free, and if you gift more than 10% of your estate the inheritance tax is reduced from 40% to 36%. There is some maths involved and you’ll need advice from an IFA, but giving 10% to charity can mean less overall tax paid and more money going to your beneficiaries.