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An introduction to inheritance tax

Paying inheritance tax

How can I reduce inheritance tax?

Creating a will

Useful links

Disclaimer: The information in this guide is for general guidance on your rights and is not legal advice.

An introduction to inheritance tax

People want to guarantee their loved ones have a secure financial future. That’s why it’s important to write a will.

A will legally ensures your assets are left to the people you choose – typically family. But, According to a 2016 poll by Opinium, 59% of adults don’t have a will. Some people don’t think they have anything worth leaving. A lot of individuals don’t realise the value of assets they do have, such as pensions.

Underestimating the importance of wills can have huge consequences. Your assets could include:

  • Cash in the bank
  • Investments
  • Any property, land or businesses you own
  • Vehicles
  • Furniture
  • Shares
  • Trusts
  • Pay-outs from life insurance policies
  • Pensions
  • Personal items

If the value of your assets reaches anything above £325,000 (or over £650,000 for a married couple or a couple in a civil partnership), your estate will owe inheritance tax at 40%. Thinking about the financial future of your loved ones isn’t just about writing a will. It’s about ensuring they don’t pay unnecessary taxes. A key motivation for people to write a will is to reduce the inheritance tax bill.

Why does anyone have to pay inheritance tax?

Do you think it’s strange people are taxed on estates they inherit? You wouldn’t be the first. Inheritance tax was created to redistribute some of the wealth of the rich. It goes to the state for the benefit of all, but it’s not hard to see why so many people think it’s unfair. When the money was originally earned, tax would have been paid. With inheritance tax, it feels like you’ve paid twice.

Who pays inheritance tax?

Inheritance tax applies to your estate. The estate must pay its tax bill before the assets can be passed on to beneficiaries. These are the people, as set out in the will, who are receiving money, possessions or property. But not that many people meet the threshold and pay inheritance tax. Just 40,100 families (around 8% of estates) will pay any inheritance tax in 2016/17, according to the Office for Budget Responsibility (OBR).

It’s natural to want to reduce your family’s tax bill if you think your estate might be worth more than £325,000. This guide will outline everything you need to know about inheritance tax, estate planning, and how much you can give away as gifts.

What should usually happen when someone passes away?

  1. Check if there's a will
  2. Apply to get a grant of representation
  3. Pay any inheritance tax that's due
  4. Collect the estate's assets
  5. Pay any debts
  6. Distribute the estate

Source: Gov.uk

Introduction to distributing wealth after death

No-one wants to think about their hard-earned wealth going to waste after they die. It’s up to you to decide who gets what. The people who could benefit from your estate include your partner or spouse, children and other family members, friends and charities. Family dynamics are complex, but they tend to be the main beneficiaries.

Sorting out your finances early can help the people left behind when you die. Remember to talk to the people your choices impact. After all, they’re the people who need to get clued up on the different taxes they might have to pay.

Valuing the estate of the deceased

When someone dies, you need to find the market value of their assets. In other words, a realistic selling price. You have to do this before you can get a grant of representation. This is also known as “grant of probate”, “letters of administration” or “letters of administration with a will”. It gives you the legal right to deal with their property, money and possessions as instructed in their will. You’ll need a grant unless the following applies:

  • The estate passes to the surviving spouse or civil partner because it was held in joint names.
  • The estate doesn’t include land, property or shares.

According to the UK government, you can use estimates to value an estate if:

  • The estate’s “gross” value is less than £200,000 (the gross value is the value of assets plus gifts).
  • The entire estate passes to the deceased person’s spouse or civil partner, a charity or organisations such as museums or community sports clubs.

Otherwise, you should get valuations from a professional. In fact, you should get a professional’s opinion on anything worth over £500. If the estate includes joint assets, value the whole asset, then work out the share owned by the deceased.

Bear in mind your valuation is only a starting point. HM Revenue and Customs (HMRC) can contact you if they want to discuss the value of the estate. If the estate is liable for inheritance tax, your valuations are more likely to be challenged.

Top tips for a valuing an estate

When someone dies, it’s a stressful and emotional time. And it’s easy to get lost in what feels like a mountain of paperwork when you’re sorting someone’s assets. To help, we’ve highlighted two things that might be forgotten:

  • Find out the value of any gifts. Gifts given away in the seven years before someone died count towards the value of the estate. As such, they might incur inheritance tax. You’re expected to make efforts to identify gifts made by the deceased. Do this by looking at bank statements and personal documents, as well as chatting to their friends and family.
  • Find out how much debt they have. Debts could include a mortgage, credit cards, loans, or any outstanding bills. Finding out what the estate needs to pay will reduce stress.

How much is inheritance tax?

An estate will owe tax at 40% on anything above the £325,000 inheritance tax threshold. This threshold doubles to £650,000 for married couples or couples in a civil partnership. So, if you leave behind assets worth £400,000, your estate won’t owe any inheritance tax on the first £325,000. It will owe 40% on the remaining £75,000 – making the total tax bill £30,000. If you had the same assets but were part of a married couple, you wouldn’t owe anything because you’ve got double the allowance. These threshold limits are frozen until at least 2020/21.

The tax is lowered to 36% if you leave at least 10% to charity. But we’ve got more on reducing your tax bill later.

Recent changes to inheritance tax

From April 2017, you get a tax-free main residence allowance on top of the inheritance tax threshold. It’s valid on your main home if you’re planning to leave it to your children, step-children or grandchildren.

The allowance will be phased in gradually. It started at £100,000 – meaning your total allowance, before inheritance tax applies, rises to £425,000 or £850,000 for couples. Every year, this allowance will rise by £25,000 until it reaches £175,000 in 2020. It only applies to your family home – the value of buy-to-let and second properties will count towards the size of the estate, as normal.

  • The average bill for an estate paying inheritance tax is over £170,000.
  • Half of UK inheritance tax is paid by estates in London and the South East.
  • UK inheritance tax receipts exceed £3bn from 17,900 estates.

Source: Prudential

In 2020, the total allowance for single people will be £500,000. For couples, the tax-free amount rises to £1 million – because each individual gets the extra £175,000 allowance. When one dies, their allowance is passed to the survivor so the allowance for the estate remains the same.

On houses worth between £1 million and £2 million, inheritance tax will be paid at the normal 40% tax rate on the amount above the allowance.

Estates worth more than £2m will see the new inheritance tax break clawed back, losing £1 of the allowance for every £2 in extra wealth.

In other words, couples with properties worth more than £2,350,000 won’t qualify for the additional allowance.

Paying inheritance tax

Who is responsible for paying?

The estate is responsible for paying inheritance tax to HM Revenue and Customs (HMRC). The person dealing with the estate – the executor – should organise this. Ideally, they’ll use money from the estate but this isn’t always possible. Once the tax has been paid, they can distribute the assets as set out in the deceased’s will.

When and how to pay your inheritance tax bill

From the date of death, you have a year to fill in the inheritance tax forms. After six months, the estate will be charged interest. To avoid excessive charges, it’s worth paying all, or some, of the inheritance tax early on.

You can pay inheritance tax in full, or you can start making payments before you know the exact amount owed. These are known as payments on account. However you want to pay your inheritance tax bill, you need to follow these steps:

  1. Get an inheritance tax reference number from HM Revenue and Customs – at least three weeks before you make a payment. You can apply online, or by post using the application form IHT422.
  2. Make payments. You can pay from your own bank account and claim the money back from the estate at a later date with a grant of representation (known as probate, or confirmation in Scotland). You can also do this with a joint account you shared with the deceased. To pay from your account, you have a few options:
    1. Use online or telephone banking with your inheritance tax number as the payment reference
    2. Sort code Account number Account name
      08 32 10 12001136 HMRC Inheritance Tax

      Source: Gov.uk

    3. Use CHAPS or BACS with the same details as above
    4. At your bank or building society using the payslip sent by HMRC
    5. By cheque through the post including the payslip

    You can also pay from accounts owned by the deceased using the same methods, or use national savings and investments or government stock they owned.

  3. Check your payment has been received. HMRC won’t send you a receipt for the payments you make. They’ll send you a letter when you’ve paid all the inheritance tax and interest owed by the estate. If you’ve paid through a bank or building society, you can check statements to confirm the money has left the account.

How can I reduce inheritance tax?

Inheritance tax is a financial fact. That’s not to say you can’t minimise taxes, court costs, and unnecessary legal fees with effective estate planning. You’ve just got to understand what needs to be paid, when and how, as well as where you could make huge savings.

Setting up a trust can reduce the amount of tax an estate must pay and increase the amount of money for families. For example, by setting up a trust for your children, inheritance tax will be charged at 20% for the amount that exceeds the normal threshold. However, if you die within seven years of setting up the trust, an additional 20% is charged – making it equal to the non-trust rate.

There are other ways of reducing your inheritance tax bill, including:

  • Giving money or property to a spouse
  • Making gifts to other family members
  • Giving money to charity

How much you can give away as a gift

If you’re married or in a civil partnership, you can give your possessions to your partner without worrying about the estate paying inheritance tax on what it’s worth. All transfers between such couples are tax-free.

What you decide to give other family members and friends is up to you. But gifts can easily incur tax if you don’t plan well. The current rules allow you to pass on money, property or possessions without paying inheritance tax, as long as you survive for seven years after the gift has been given.

You can’t plan the time of your death. But, by understanding inheritance tax, people tend to decide to make generous gifts whilst they’re still healthy and feeling good. If something was to happen, the estate would owe some inheritance tax. The rates follow a taper system, as shown in the table below. For example, if you die within six years, the estate will pay 8% inheritance tax on any gift over the threshold.

IHT taper rates for gifts
Time since the gift IHT rate
7 years 0%
6-7 years 8%
5-6 years 16%
4-5 years 24%
3-4 years 32%
less than 3 years 40%
source: HM Treasury

There are some exceptions that allow you to give more without paying tax.

  • You can give up to £250 a year to as many people as you like
  • Anyone can give away up to £3,000 tax-free a year. If you don’t use this annual exemption, it can be carried over for the following year but only up to a maximum of £6,000
  • Gifts made at the time of a wedding or civil partnership are given tax-free allowances:
    • £5,000 can be given to a child
    • £2,500 can be given to a grandchild or great grandchild
    • £1,000 can be given to anyone
  • If you can show the gift was funded out of surplus income, not savings, you won’t pay inheritance tax. But it’s a complicated matter to prove, and you need to make a written declaration confirming the gifts are paid for out of income, not from savings or investments.

Exemptions from inheritance tax

In addition to exemptions on gifts, not everyone will have to pay inheritance tax. You qualify for relief if the following applies:

  • If you’re in the armed forces, police, or are a firefighter, paramedic, or humanitarian aid worker, and die in active service, your estate doesn’t have to pay inheritance tax. This includes people injured during active service and whose death was hastened as a result.
  • Businesses can qualify for either 50% or 100% tax relief – find out more from gov.uk
  • You can pass on a farm without worrying about inheritance tax, but certain assets, including machinery, will still need to be valued to check if tax is owed on them.
  • The land of woodland properties isn’t subject to inheritance tax, although the trees will be if they’re sold or given away as timber.
  • Heritage assets, including buildings, land, or objects of national scientific, historic or artistic importance, could be exempt from inheritance tax.

Qualifying for relief is a complicated process. It’s worth contacting the government’s inheritance tax and probate enquiries office to get additional support.

Advice on inheritance tax and spouses

When you get married or enter a civil partnership, you share your assets but still get individual allowances for the inheritance tax threshold. As a couple, this means you can pass on assets worth £650,000 before inheritance tax will be owed. What’s more, this tax-free allowance can be passed on after the first death.

If your spouse dies, and you inherit all assets tax-free, the individual tax-free allowance won’t have been used. When you pass away, your estate will be able to use this doubled allowance.

You’re allowed to do this with a portion of allowance – for example, if the assets passed on to other family members after the first death totalled £162,500, only 50% of the tax-free allowance has been used. At the time of your death, you’d be able to pass on assets worth £487,500 before any inheritance tax is due. This rule applies if your partner has already died, as long as they died after 12 November 1974.

A guide to giving to charity

Many individuals are keen to remember a charity in their will – recent research commissioned by the British Heart Foundation suggests around 43% of people intend to leave money to charities. As well as a sense of general wellbeing, big donations can reduce the amount of inheritance tax you pay. You can donate a fixed amount, an item, or whatever is left after other gifts have been given out. Your donation can either:

  • Be taken off the value of your estate before inheritance tax is calculated
  • Reduce your inheritance tax rate – but only if more than 10% of your estate is left to charity

If you decide to leave at least 10% of the net value of your estate, the rate of inheritance tax reduces to 36%. This could save you thousands of pounds – to show you how, consider the following scenarios:

How donating to charity can reduce your inheritance tax bill

When you died:

  • You weren’t married or in a civil partnership so don’t qualify for the spouse transfer exemption
  • You left everything to your partner in your will
  • Your net estate was worth £425,000
  • With the threshold allowance, there is inheritance tax to pay on £100,000 at 40%

Without a charity donation:

  • You would pay inheritance tax at 40% making the bill total £40,000

With a charity donation:

  • You would leave £415,000 to your partner
  • You’d leave 10% of your estate that qualifies for inheritance tax to a charity (£10,000 in this case)
  • Your estate would pay 36% on £90,000 making the inheritance tax bill £32,400

Source: The Money Advice Service

Creating a will

Creating a will is something everyone should do. It ensures your money, possessions and even personal items go to who you want. Discussing death can be sensitive, but a will makes it easier for your family to sort everything out. Without a will, funeral arrangements and distributing your estate is difficult and time-consuming. A good will should include:

  • Who you want to inherit your money, property and possessions when you die
  • Who will be the executor of your will (the person in charge of organising your estate)
  • Clear instructions for the executor
  • Any other wishes – including instructions for your funeral

For your will to be legally valid, it should include the following details:

  • How your estate should be shared out
  • Confirmation you made these decisions yourself and without pressure
  • Signed and dated by you in the presence of two independent witnesses – these adults can’t be people who are set to inherit anything from you, and they must sign the document too

Source: The Money Advice Service

A will doesn’t have to be full of complicated, legal language. You can buy template documents for as little as £10. A specialist will writing service costs on average between £75 and £150. Or you could use a solicitor for prices starting around £150 – the cost will rise if your circumstances are complicated.

Advice on talking to loved ones about your will

Talking about death is always an uncomfortable subject – especially when you’re discussing with your family what will happen to your money. People don’t want to think about those close to them dying.

It’s a conversation that should happen between loved ones. Letting your family know what your wishes are minimises the stress for them when the time comes. It can also help prevent arguments and resentment about the division of your estate. Things to discuss include:

  • Funeral arrangements. Most people have an idea of what sort of funeral they’d like – whether they want to be buried or cremated, for example. Make these wishes known, along with suggestions of music, flowers and location. You should also let your family know if you have a pre-paid funeral plan, or how you would like it paid for.
  • Family heirlooms. Distributing personal items with sentimental value, such as jewellery or art, can be one of the trickiest things to discuss. Your family might be attached to some of your things. Give them a chance to let you know what they’d like to be left before you come to an agreement. These things won’t be useful to you after you pass. It’s best for heirlooms to go to people who’ll really treasure them.
  • An explanation of division. When it comes to money, even the strongest relationships can be tested. While the people you leave your assets to don’t need to know the full extent of your estate, it’s important to discuss in order to set expectations. The more it’s worth, the more you might want to say.

    For example, if you decide to unequally distribute your wealth, you should talk through your reasons. If one child earns significantly more than the other, you may allocate accordingly – but let them know why. No-one should assume money is coming their way, but talking it through will let them plan for their future. If you’re passing on a business they’re expected to run or sell, you need to go into more detail.
  • The executor of your will needs to be on board with your plans, as they’re the individual responsible for managing your assets until they’re distributed. They’ll take care of your remaining financial obligations too. Given the burden of paperwork and potentially delicate nature of a will, it’s important to get their permission and discuss in detail.

The benefits of planning ahead

Did you know you already have an estate plan? The government has general, default laws that are used to manage your estate when you die. They’re generic and don’t consider individual wishes. Most of the time, these plans of action don’t reflect what you’d want to happen. Failing to make a will lets someone else call the shots. It should be your decisions that shape the future of your estate after death.

Do things on your terms by creating a will with clear instructions. You might think you’re too young to need a will, or don’t own enough assets for it to be worthwhile, but everyone should plan ahead. Your family and friends aren’t experts in legal matters. By setting out all the details in a will, you’ll make it easier for them.

Tips on choosing an executor

People who care about their family will make sure everything happens in an orderly way with a good will. They’ll make decisions about splitting their assets that consider the best interests of those close to them. It might take them some time, but it will have a positive effect in the long term.

But to ensure these wishes are carried out as intended, you’ve got to choose a responsible executor. Whoever you choose, sit down with them and walk them through what you want to happen. Here are some things to bear in mind:

  • This person is often a family member – but doesn’t have to be
  • You can choose more than one executor
  • A person can both benefit from the estate, and be the executor
  • Other suggestions for an executor include an attorney, friend, or accountant

Death is never an easy topic to deal with. With this guide, you can plan for the future and ensure your family don’t pay unnecessary tax.

You shouldn’t take steps that could leave you struggling while you're alive to save tax after you've died, but you can easily make savings for your loved ones with tax-free gifts and by reviewing what your estate is worth.

As the total amount of inheritance tax paid increases, it’s important to plan what happens to your estate after you pass. Anyone looking to pass wealth to their families should discuss financial plans with professional advisors. It’s never too early to start planning.