What is inheritance tax (IHT) and how does it work?

IHT is a tax which may be paid on your estate (your money, possessions and your share of any property) when you die, reducing how much value will ultimately pass to your beneficiaries. Your beneficiaries are the people you want to leave your money and assets to when you die.

Inheritance tax may also be levied on certain gifts you make while you are still alive, but we’ll cover that in more detail later in this guide.

IHT is currently applied to estates worth more than £325,000 - though this threshold is likely to change in future. When the value of your estate exceeds the limit, known as the ‘nil-rate band’, everything over the threshold is taxed at 40% (unless you’re leaving it to your surviving spouse, in which case no IHT needs to be paid).

The tax is levied on the worldwide assets of ‘UK domiciled individuals’ (people whose permanent home is in the UK). It also applies to the UK assets of people who live abroad.

That means if you’re a UK citizen and you have a holiday home abroad, it still counts as part of your estate for IHT purposes. Similarly, if you’re a foreign national but have UK property or assets, you’ll be liable for UK inheritance tax if the value of those assets comes to more than the £325,000 limit.

Understanding the nil-rate band

With lots of rules, exceptions and reliefs, inheritance tax can get quite complicated – but understanding the nil-rate band is key to it all.

The nil rate band is, in effect, a personal IHT tax allowance. Every person who is subject to potential IHT has their own £325,000 allowance, and you’ll only become liable for inheritance tax if your estate exceeds that amount.

This allowance can be increased in certain circumstances, too. For example, if you were to leave your main residence to a direct descendant when you die, an additional ‘residence nil-rate band’ will be added.

For the 2020/2021 tax year, the maximum residence nil rate band is £175,000. This gets added to your existing nil-rate band of £325,000 - so your estate could be worth up to £500,000 before any IHT is payable. 

For example, let’s say you leave behind…

  • Savings, investments and possessions worth £110,000
  • Your main residence, worth £340,000

The total value of your estate is £450,000, which would ordinarily exceed the nil-rate band. However, if you leave the property to a direct descendant, the residence nil rate band extends your allowance to £500,000 (£325,000 + £175,000).

Not only does this mean no inheritance tax would be due, it also means £50,000 of your nil rate band would go unused. This unused proportion of your allowance can be transferred to the estate of your surviving spouse, thus increasing their nil rate band for the future.

Note that if you co-own your property, only the value of your share will be counted among your estate. In the case above, if you had a 50% share in the house, it would be worth £170,000 – so even combined with your savings and possessions, you’d be within the nil-rate band regardless of who you left your estate to.

Inheritance tax for married couples

We’ve already seen how being married or in a civil partnership can bring some major benefits when it comes to IHT.

If your will passes all your assets to your wife, husband or registered civil partner, then there won’t normally be any IHT to pay. What’s more, your nil-rate band won’t be used at all – so your surviving partner can effectively double theirs.

It’s up to the legal personal representatives of the second spouse or civil partner to claim the transfer of the unused nil-rate band when the second partner dies. Doing so can significantly reduce the inheritance tax that’s due on assets passed down to your offspring, or other family and friends.

Here’s a quick example of how it works

Mr Smith died in 2018, leaving his estate to his wife. As the assets passed to his spouse, none of Mr Smith’s nil-rate band was used. Mrs Smith then passes away in 2020, with a total estate worth £600,000 left to nieces and nephews. 

As none of Mr Smith’s nil-rate band was used, 100% of it (£325,000) can be added to Mrs Smith’s own nil-rate band (also £325,000), increasing Mrs Smith’s nil rate band to £650,000. 

As a result, no IHT needs to be paid. 

If Mr Smith’s nil-rate band hadn’t been transferred, then £110,000 IHT would have to be paid. This is 40% of £275,000, the value of Mrs Smith’s estate (£600,000) less her own nil rate band (£325,000).

How much inheritance tax you might have to pay

Given the rapid rise in house prices over recent decades, more and more people find their estates exceeding the IHT threshold even with the benefits of the residence nil-rate band.

In the table below, you can see how much inheritance tax might be payable on your estate, whether you’re able to claim the full £175,000 relief against the value of your home or not.

Note, this doesn’t take into account any extra allowance you may be able to claim following the death of a partner.

Total value of estate
IHT payable if full residence nil rate band of £175,000 claimed
IHT payable if no residence nil rate band applicable
£325,000
None
None
£400,000
None
£30,000
£500,000
None
£70,000
£600,000
£40,000
£110,000
£800,000
£120,000
£190,000
£1m
£200,000
£270,000

Inheritance tax on gifts

Giving money or assets to your beneficiaries while you’re still alive is one of the most common strategies to pre-emptively reduce inheritance tax.  However, there are a number of rules around what you can give, and when you can give it.

Indeed, when the value of your estate is calculated, it will include the total value of certain gifts you made in the seven years before your death, or at any time if you continued to benefit from the gifted property thereafter (these are known as ‘gifts with reservation of benefit’).

Lifetime gifts generally fall into one of the following three categories: 

Exempt transfers

Exempt transfers are gifts you can legitimately make at any time, without incurring any inheritance tax. These include:

  • Gifts of any value between spouses or registered civil partners 
  • Annual gifts of up to £3,000 in each tax year
  • Regular payments out of your income. Regular payments paid directly out of your income can help stop the value of your estate increasing. There’s no set limit on these payments, but they will only qualify for exemption if you have enough income left to fund your normal lifestyle.
  • Wedding gifts or civil partnership ceremony gifts (you can give £5,000 to your children, £2,500 to grandchildren or £1,000 to anyone else).
  • Small gifts of up to £250 per person, per year
  • Gifts to charities, political parties or national organisations (donations are tax-free during your lifetime, and when you leave money to charity in your will).

Potentially exempt transfers (PETs)

Potentially exempt transfers (PETs) are gifts to individuals (as well as gifts into certain specific types of trusts) which exceed the available exemptions above. 

There is no inheritance tax to pay straight away when you make the transfer, but IHT will need to be paid if you die within seven years and the value of the PET puts you over the nil rate band.

Gifts made less than three years before your death incur the full 40% tax charge. Gifts made three to seven years before you die are taxed on a sliding scale known as taper relief.

For example, if you make a PET of £100,000 but die within three years with an estate value of £300,000, the PET is added to the value of your estate to make £400,000. There’ll therefore be an IHT bill of £30,000 (40% of the £75,000 over the nil rate band). 

Assuming you live for more than seven years following the PET, its value wouldn’t be added to your estate when you die. In this case, there would be no inheritance tax to pay on the gift.

Chargeable lifetime transfers

A transfer is classed as a chargeable lifetime transfers (CLT) when an individual makes a gift that is not outright, for example, a gift into a flexible or discretionary trust.

There will be no inheritance tax to pay when making a CLT, as long as your total amount of CLTs in the previous seven years is less than the available nil rate band. 

If the CLT, when added to the total amount of CLTs in the previous seven years exceeds the nil rate band, there will be a lifetime inheritance tax charge of 20% on the excess amount.

Chargeable lifetime transfers will usually fall outside of your estate for IHT purposes if you survive for at least seven years after the CLT was made. However, if you die within seven years of making the CLT, then its value will be part of your estate. 

Any inheritance tax you already paid on a CLT when you were alive will be deducted from any IHT due on it after your death. 

Things to consider before making lifetime gifts

Lifetime gifts are often seen as a simple way to reduce inheritance tax, but as you can see above, it’s a complicated matter that needs serious thought. 

As well as ensuring you abide by the rules, you’ll need to consider the affordability of giving gifts, without leaving yourself short in your later years – when you may need to pay for things like care.

You’ll also need to think about when you want your beneficiaries to gain access to the assets you gift them. For instance, you may want to give money to your children or grandchildren but retain control over what age they receive it. This can usually be done by placing the money into trust.

If you’re looking at ways to manage your estate value, it might be a good idea to speak to a Wesleyan Financial Services Consultant for expert advice. 

Please bear in mind that advice in relation to inheritance tax planning is not regulated by the Financial Conduct Authority.

Using trusts to reduce inheritance tax

A trust is a legal arrangement you can create where your asset (or your gift) is held by a trustee or group of trustees, for the ultimate benefit of a named third party (your beneficiary). 

When the investment is transferred to the trustees, it no longer technically belongs to you – so it won’t be counted as part of your estate when you die (subject to all the other rules above). This can significantly reduce inheritance tax liability for the people you’re passing the assets to. 

What’s more, if you gift money into a trust, you can control how and when the money is paid out. It’s a way of making sure your plan is dealt with in line with your wishes when you die.

Just bear in mind that you may lose access to the money yourself once it goes into trust. That’s why you should always discuss things with an expert before making any big decisions.

Tax treatment depends on the individual circumstances and may be subject to change in future.

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