How Does Inheritance Tax Work?

Inheritance Tax (IHT) is usually paid on an estate (all assets, less any liabilities) when somebody dies. There is a lifetime rate of IHT, but that is only payable on certain gifts into a Trust or gifts to a corporate entity, not to an individual.

Most estates don’t have to pay IHT because they’re valued at less than the threshold (£325,000 in 2023/24) (£500,000 if the full Residential Nil Rate Band [RNRB] applies). The tax is payable at 40 per cent on the amount over this threshold or 36 per cent if the estate qualifies for a reduced rate as a result of a charitable bequest (minimum 10% of the taxable value of the estate).

Since October 2007, married couples and registered civil partners can effectively increase the threshold on their estate when the second partner dies to as much as £650,000 in 2023/24 (£1,000,000 with the full RNRB). Following the death of the first spouse or civil partner, any unused IHT NRB and RNRB can be transferred to the second spouse or civil partner when they die.

In many ways, IHT has a “stealth tax” element to it because the main NRB has been frozen at £325,000 since 06 April 2009 and the RNRB at £175,000 since 06 April 2020, with them set to stay at that level until at least 05 April 2028. With the increase in asset values, more and more estates are being drawn into the realms of paying tax.

IHT Exemptions

Sometimes, even if your estate is over the threshold, you can pass on assets without having to pay IHT. Examples include:

  • Spouse or civil partner exemption. Your estate usually doesn’t owe IHT on anything you leave to a spouse or civil partner who has their permanent home in the UK – nor on gifts you make to them in your lifetime – even if the amount is over the threshold.
  • Charity exemption. Any gifts you make to a ‘qualifying’ charity – during your lifetime or in your will – will be exempt from IHT. A donation to charity in your will may also reduce the rate at which tax is paid.
  • Potentially Exempt Transfers (PETs). If you survive for seven years after making a gift to someone, the gift is generally exempt from IHT, no matter what the value.
  • Chargeable Lifetime Transfers (CLTs). If you place assets into a Trust, it is generally a CLT and subject to IHT at 20%, if the amount is over the NRB. Like PETs, CLTs are out of the IHT reckoning after 7-years.
  • Annual exemption. You can give up to £3,000 away each year, either as a single gift or as several gifts adding up to that amount and you can also use your unused allowance from the previous year, but you use the current year’s allowance first.
  • Small gift exemption. You can make small gifts of up to £250 to as many individuals as you like tax-free, but not in addition to anyone receiving a more substantial gift against which you are claiming the Annual Allowance.
  • Wedding and civil partnership gifts. Gifts to someone getting married or registering a civil partnership are exempt up to a certain amount, depending how you are related to the parties.
  • Gifts out of income. Any regular payments made to someone that are demonstrably affordable out of income, i.e., the Donor still has adequate income to maintain their standard of living, are exempt.
  • Business, Woodland, Heritage and Farm Relief. If the deceased owned a trading business, a working farm, woodland, or National Heritage property, some relief from Inheritance Tax may be available.

How does Inheritance Tax work?

On death everything the person owns has to be valued – property, personal possessions, cash, savings, investments, etc., including their share of items owned jointly with somebody else. From this is deducted any liabilities outstanding at the date of death – funeral costs, mortgage, household bills, credit cards, etc., to arrive at the net total. The taxable amount is then calculated by deducting any of the Allowances/Exemptions referred to above and the relevant NRB(s).

Care needs to be exercised with the value of certain gifts, as the legislation stipulates that the value is related to the reduction in the overall size of the Donor’s estate. For example, someone who owns a pair of Ming vases decides to give one away and keep the other; each vase is valued at £300,000, but the pair would command £1,000,000 at auction. The value of the gift is not £300,000, but £700,000, as this is the effective drop in the overall value of the estate.

Who will have to pay IHT?

On an estate, it’s the Personal Representative; the Executor if there’s a Will, or Administrator if there is none. In a Trust, it’s the Trustee. The tax is deducted from the funds held by the Personal Representative or Trustee, so it comes out of the beneficiaries’ shares in the end, so anything received by way of an inheritance is already tax-paid. However, there may be some Income Tax to pay, if the inheritance includes income received during the administration of the estate. Assets, such as shares, transferred in specie, are deemed to be acquired at the probate value, so a subsequent sale may then incur a Capital Gains Tax liability.

Great care needs to be exercised by those receiving a lifetime gift, particularly a substantial sum, which would be classified as a “PET” (see above), as you could be faced with an IHT liability if the Donor dies within 7-years. This could be potentially embarrassing if the money has already been spent! All recipients of such gifts should consider insuring the life of the Donor against this eventuality.

If you believe you have a potential IHT problem and want to know what legitimate steps you can take to mitigate this, contact me today, or complete the form below.

    - Inheritance Tax

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    About Clive Barwell

    Clive Barwell is one of the most experienced and qualified financial planners working in the later life market today, he specialises in advice and guidance for the over 55s. To ask Clive a question, please email him at Alternatively, you can follow Clive on Twitter, connect with Clive on LinkedIn or see Clive's profile on Google+.