Must knows when it comes to Inheritance Tax

Did you know:

Inheritance tax can cost loved ones hundreds of thousands of pounds after your death, generating ￡7 billion for HM Revenue & Customs in a recent tax year. However, around 96% of people don’t pay any inheritance tax, and those who do can often legally reduce the amount.

Here are five essential points about inheritance tax:

1. Exemption for Spouses and Civil Partners

Inheritance tax applies to the estate of someone who has passed away, but only about 4% of families end up paying it since most estates fall below the threshold. If the deceased was married or in a civil partnership, anything left to their spouse or civil partner is exempt from inheritance tax, regardless of the estate's value. This exemption does not apply to cohabiting partners.

2. ￡325,000 Tax-Free Allowance

Everyone has a ￡325,000 inheritance tax-free allowance. If the estate or any portion not going to a spouse/civil partner is below this amount, no inheritance tax is due. The estate's value is calculated by adding up assets like cash, investments, property, vehicles, and life insurance pay-outs, minus any debts. Any amount above ￡325,000 is taxed at 40%, or 36% if at least 10% of the estate's value is left to charity. This allowance can be increased to over ￡500,000 depending on the circumstances.

3. Boosting Allowance to ￡500,000 by Passing on Your Home

In the 2024/25 tax year, no inheritance tax is due on the first ￡325,000 of any estate. An additional ￡175,000 allowance, the 'residence nil-rate band' (RNRB), applies if you leave your home to direct descendants (children or grandchildren). This can increase the tax-free threshold to ￡500,000. However, this allowance decreases for estates worth over ￡2 million and doesn't apply if the home is in a discretionary will trust.

Here’s an example that might help clarify this more...

Let's say you've got an estate worth ￡525,000, including a home worth ￡200,000. You've decided to leave your home to your children. This means no inheritance tax will be charged on the first ￡500,000 (￡325,000 NRB + ￡175,000 RNRB). There'll be a 40% charge on the remaining ￡25,000 value of your home, giving a total of ￡10,000 in tax (presuming you're not leaving anything to charity).

If you weren't leaving your home to your direct descendants, there would be nothing to pay?on the first ￡325,000 of your estate, and 40% on the ￡200,000 value of your home, meaning a total of ￡80,000 to pay in inheritance tax.

A big difference that could cost you in the example and additional ￡70,000 in Inheritance tax!

4. Unused Allowance Transfers to Spouse

Any unused inheritance tax allowance can be transferred to a surviving spouse or civil partner, potentially allowing a couple to leave up to ￡1 million tax-free. For example, if one spouse dies and leaves everything to the other, their ￡325,000 NRB and ￡175,000 RNRB can be transferred, increasing the surviving spouse’s tax-free allowance to ￡1 million.

This, again, can sound complicated, so here's another example for you...

Mr and Mrs Smith have assets worth ￡1 million between them. Mr Smith dies first in March 2025 – leaving everything to Mrs S?– so his ￡325,000 NRB is passed on, as well as his ￡175,000 RNRB.

In total, this means Mrs S may have an up-to ￡1 million tax-free allowance: her allowance, plus her inherited allowance from her deceased husband.

*You don't need to do anything to activate this – the executors of your will just need to send certain documents to HM Revenue & Customs (HMRC) within two years of your death. ?

5. Ways to Reduce Inheritance Tax

If you’re among the 4% who will pay inheritance tax, you can reduce the bill by making gifts during your lifetime. Gifts given more than seven years before your death are not liable for inheritance tax. Gifts within seven years are subject to inheritance tax if they exceed ￡325,000, on a sliding scale.

Certain gifts are tax-free, including:

???- Annual gifts up to ￡3,000.

?? - Charitable donations.

?? - Gifts up to ￡250 per person annually.

?? - Regular gifts from surplus income.

?? - Wedding gifts up to ￡5,000 for children, ￡2,500 for grandchildren, and ￡1,000 for others.

? - Contributions to a loved one’s living costs tuition fees at university.

o?? There are no caps on how much you can contribute, and it can be given tax-free as long as the money comes from your own regular income and doesn't affect your own lifestyle. Such funding can be combined with your ￡3,000 annual exemption (so it can be used on the same person)?but not with the ￡250 small gift allowance.

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?So what Constitutes a Gift?

A gift must be a genuine, unconditional transfer that you will not benefit from; it should be given without any reservations or expectations of something in return. For instance, while a home is often a significant asset, transferring it to your children won't work if you continue living there unless you pay them market rent.

Many gifts can help reduce your inheritance tax bill, but they must be truly unconditional. Conditional gifts, except for wedding gifts, may not be effective if there is an expectation of something in return.

For substantial lifetime gifts, beneficiaries might consider taking out life insurance to cover potential inheritance tax liabilities. Gifts placed into a trust are usually subject to inheritance tax, even if made during your lifetime, so seeking specialist advice is essential.

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