How much will Inheritance Tax be on my death and how to reduce it.
Taking time to consider what your estate is worth and how much Inheritance Tax (IHT) might be payable on your death can be a highly beneficial exercise. This is typically referred to as ‘estate planning’ and doing this has the potential to save a huge amount of tax.
This article was updated on 28 January 2022.
Taking action early means more of your money is available for your beneficiaries and less is paid out in tax.
However, estate planning isn’t just about passing on money when you die – it’s also about enjoying life now and ensuring you have enough to live on. This is why it’s so important to start planning early.
What is Inheritance Tax (IHT)?
IHT is a tax on the estate of someone who has died. Your estate is defined as your property, savings and other assets after any debts and funeral expenses have been deducted. IHT was introduced in 1986, replacing capital transfer tax, which originally replaced estate duty.
In recent years, over £5bn a year has been collected by HMRC in IHT bills and this is projected to remain the case for some years.
You can legitimately and legally reduce or mitigate IHT in a number of ways. Primarily there is a tax-free allowance which everyone is entitled to.
The (standard) Nil Rate Band (NRB).
Everyone has a tax-free inheritance tax allowance, currently £325,000 – known as the ‘Nil Rate Band’ (NRB). The allowance has remained the same since the 2010/11 tax year.
The standard inheritance tax rate is 40% of anything in your estate over the NRB.
For example, if you leave behind an estate worth £500,000, the tax bill will be £70,000, which is calculated as: (£500,000 - £325,000) = £175,000 x 40%.
However, if you are married or in a civil partnership, you may be able to leave more than this before paying tax. In the 2021/22 and 2022/23 tax years, most married couples or civil partners can pass on up to £650,000 (two times the NRB), or £1million if your estate includes your home (further details on that below), effectively doubling the amount the surviving spouse/partner can leave behind tax-free without the need for special tax planning.
The NRB will be maintained at these levels up to and including the tax year ending 5 April 2026.
The Residence Nil Rate Band (RNRB).
Since April 2017, there has been a new transferable allowance, known as the ‘Residence Nil Rate Band’ (RNRB).
Since the 2020/21 tax year, it has been £175,000 per person. Like the Nil Rate Band, the RNRB will be maintained at this level up to and including the tax year ending 5 April 2026.
To qualify, the person who died must have left their home, or a share of it, to their direct descendants. A person does not have to leave the whole of the home to direct descendants. If they only inherit a share of the home, the value of the home must be shared too. You calculate the available RNRB based on that share in value.
For example, Hannah dies and her estate includes a home worth £500,000. In her will, she leaves half of the property to her stepson (a direct descendant) and half to her friend (NOT a direct descendant).
You work out the available RNRB based on how much the property left to the stepson was worth – half of £500,000, which is £250,000. However, the actual RNRB for the estate is restricted to £175,000. This is the lower of the maximum available RNRB (£175,000) and the value of the half share of the home (£250,000).
It does not matter how the home is inherited: for example, the home can be left to a direct descendant as a specific legacy in a will; or it could be included in what is left of the estate (the residue) after specific legacies have been taken into account.
The estate may also qualify if the person downsized to a lower value property, or sold or gave away their home on or after 8 July 2015.
It is important to note that the RNRB does not apply to gifts and lifetime transfers, such as transfers into trusts.
The NRB and the RNRB combined.
You can add the RNRB to the standard NRB if the person and their estate meet the qualifying conditions. This higher threshold does not mean that the home is exempt from IHT, but that can be the result in some cases.
Additional RNRB may also be available from a late spouse or civil partner’s estate.
Usually, the order you apply the RNRB and standard NRB will make no difference. However, in some cases it will affect the amount of any unused additional or standard NRB available to transfer to a spouse or civil partner’s estate.
The RNRB and estates worth more than £2million.
The RNRB will gradually reduce, or taper away, for an estate worth more than £2million, even if a home is left to direct descendants. The RNRB will reduce by £1 for every £2 that the estate is worth more than the £2million taper threshold.
The value of the estate for taper purposes is the total of all the assets in the estate less any debts or liabilities.
For example, Sam’s estate is worth £2,100,000 on death. This includes a home worth £450,000. The estate is worth more than the taper threshold by £100,000. Therefore, the RNRB reduces by £50,000 (calculated as £100,000 divided by £2).
Potential ways to reduce or mitigate IHT.
Aside from ensuring you have a valid will that is written to ensure you are fully utilising the available allowances, there are several ways to legitimately and legally reduce the IHT bill on your death:
Spending - reducing your overall assets by spending them will in turn reduce the size of your estate and therefore reduce your IHT liability.
Insurance - you can insure against any potential IHT liability through a whole of life insurance plan. Holding it in trust means it would not form part of your estate and therefore the pay-out would not be liable to IHT.
Trusts - can be used with other assets such as investments and property. While there are many different types of trusts available, in basic terms, trusts work by placing assets outside of your estate.
Investments - you can invest money into a Business Relief (BR) product. This can be very risky but has the potential for upside benefits too and these will typically be free from IHT if held for more than two years.
Gifting - you are allowed to make some gifts without any tax being due after your death, the main two being:
You can make gifts of any amount tax-free to your spouse or civil partner (this does not include unmarried partners).
You can gift up to £3,000 in total in each tax year that you are alive. This gift is called your 'annual exemption' and any unused annual exemption can be carried forward for one year.
It must however be highlighted that you cannot gift someone something that you will still maintain a benefit from in your lifetime. Gifts made in this way are known as ‘gifts with reservation’.
For example, if you give away your home hoping to remove it from your estate for IHT purposes, but continue to live in it rent-free until your death, you will be deemed the beneficial owner, and it will still be subject to IHT on your death thereby negating the whole purpose of the exercise.
What about Pensions?
Pensions are normally exempt from IHT, so with the right planning pensions can be used as an effective way of passing on money after your death without incurring or increasing an IHT bill. This of course assumes you don’t need some or all of the pension yourself while you are alive! Look out for our next article which explores this subject in more detail.
Summary
IHT is a complex subject and only some of the main points have been covered here - in practice, when it comes to proper estate planning there is so much more to consider. If the value of your estate is large or at the very least in excess of the NRB (either singularly or jointly), it is wise to seek professional financial or tax advice.
If you would like to find out more about how we can help you, you can arrange a free no-obligation chat with us by contacting us via our website.
This article offers information about financial planning and should not be taken as personal advice. Tax rules can change and the benefits depend on individual circumstances.