Why Understanding Inheritance Tax is Crucial – Even if You Think It Doesn’t Apply!

When I mention inheritance tax, people usually have one of two reactions.

Either a sense of unease or a feeling that this does not matter to them.

If you plan to build a life of time and financial freedom, inheritance tax will almost certainly come along at some point, particularly if you are keen to leave your inheritance to your loved ones after you've gone.

Proactive planning is key. The earlier you address the inheritance tax issue, the easier it is to manage. By taking steps now, you could potentially save your loved ones from a significant financial burden.

If your estate exceeds ￡325,000, a 40% tax could apply to the excess. But rest assured, you're not alone in this. There are legal ways to reduce or even eliminate this tax liability, providing you with peace of mind.

This blog looks at inheritance tax, how it works in the UK. Most importantly—strategies to minimise the tax and keep more of your hard-earned assets within your family.

What is Inheritance Tax?

An inheritance tax is a tax on the estate of someone who has died, including their property, money, and possessions. In the UK, the standard inheritance tax rate is 40%. Still, it only applies to the part of the estate above the ￡325,000 inheritance tax threshold. This threshold, known as the 'nil-rate band,' is the amount of your estate that is not subject to inheritance tax. If your estate is valued under ￡325,000, you will not need to pay any IHT.

You might be wondering if this tax applies to your estate. If you own property, investments, savings, or other valuable assets such as a business, a second home, or valuable personal items, your estate could likely be over this threshold. It's important to know the exact value of your estate to determine your potential inheritance tax liability. And remember, inheritance tax is based on the total value of everything you own, not just your home or savings. It includes things like life insurance policies not held in a trust, and even gifts you've given in recent years.

How is Inheritance Tax Calculated?

To calculate inheritance tax, first, you need to add up the total value of your estate. This includes all assets such as property, savings, investments, personal belongings, and gifts made in the last seven years. Once you've calculated the total value of your estate, you subtract the ￡325,000 inheritance tax threshold. Anything over this amount will be taxed at 40%.

Here's a basic example:

• Estate value: ￡600,000
• Inheritance tax threshold: ￡325,000
• Taxable amount: ￡275,000
• Inheritance tax due: ￡275,000 x 40% = ￡110,000

In this scenario, ￡110,000 of inheritance tax would be due. However, don't panic! There are many ways to reduce or eliminate this liability; we'll cover those strategies next.

It is worth noting that you do not pay any inheritance tax when you die if you're passing over your estate to your husband/wife or civil partner.

In addition, any unused inheritance tax allowance when you die can be passed over to your spouse/civil partner.

In the example above, this would mean a couple with an estate value of ￡600,000 would have an IHT allowance of ￡650,000 if one of the couple died. Therefore, no inheritance tax would need to be paid.

How to Reduce Your Inheritance Tax Liability

Now that you know how inheritance tax works, let's explore (legal) ways to reduce your liability. It's possible to structure your estate to minimise inheritance tax, meaning more of your wealth stays in the family.

Here are some of the most common strategies used to reduce the inheritance tax burden:

Use Gift Allowances

One of the simplest and most effective ways to reduce your estate's value is by giving away some of it before you pass. The UK government allows you to gift up to ￡3,000 each tax year without it being subject to inheritance tax. This is your annual exemption, and if you didn't use your gift allowance last year, you can carry it forward. This effectively doubles your allowance to ￡6,000.

You can also make smaller gifts—up to ￡250 per person each tax year—to as many people as you like. This does not count towards your estate's value. Gifts made to your spouse or civil partner are also tax-free. Consider gifting assets to them if your estate exceeds the inheritance tax threshold.

In addition, if you give away larger gifts, they may still be exempt from inheritance tax if you survive seven years after giving them. This is called the 'seven-year rule.' If you survive for seven years after making a gift, it is no longer counted as part of your estate for inheritance tax purposes. This is a powerful way to reduce inheritance tax if you start gifting assets early.

Use Trusts

Trusts are another highly effective method for reducing your estate's value and passing on wealth to your heirs. A trust is a legal arrangement where assets are held by one party (the trustees) for the benefit of another party (the beneficiaries). Trusts can help you control when and how your assets are distributed while reducing inheritance tax.

For example, setting up a discretionary trust allows you to pass on assets to your children or grandchildren without them immediately owning them. Because the assets are no longer part of your estate, their value is excluded from inheritance tax calculations.

Another option is a bare trust, in which the assets are passed directly to a named beneficiary, often a child or grandchild. This is typically used for younger beneficiaries and is a straightforward way to reduce an estate's value.

It's worth noting that trusts are complex legal arrangements, and the tax implications can vary depending on the type of trust you set up. It's a good idea to consult with a financial adviser or estate planner to ensure you're using trusts effectively.

Take Out a Life Insurance Policy

If you're concerned about your family's ability to pay inheritance tax after you pass away, consider taking out a life insurance policy. The policy will pay out a lump sum upon your death, which your beneficiaries can use to cover any inheritance tax due.

However, the life insurance policy must be written in trust for this to work effectively. If not, the payout could be considered part of your estate and subject to inheritance tax. The payout will be outside your estate and free from tax by placing the policy in trust.

Life insurance is not a way to reduce inheritance tax. Still, it can provide a financial safety net for your heirs, ensuring they have the funds needed to cover any tax liability.

Leave Money to Charity

Another way to reduce your inheritance tax bill is by leaving a portion of your estate to charity. Any money left to a UK-registered charity is exempt from inheritance tax. Moreover, if you leave at least 10% of your estate to charity, the inheritance tax rate on the rest of your estate drops from 40% to 36%.

This is a great way to reduce tax liability and support a cause you care about. It also provides an opportunity to leave a lasting legacy through charitable giving.

Business and Agricultural Relief

If you own a business or agricultural property, you may qualify for business relief or agricultural relief, which can significantly reduce the value of these assets for inheritance tax purposes. Sometimes, you could pass on these assets free of inheritance tax altogether.

• Business relief: If you own a business or shares in a qualifying business, you may be eligible for up to 100% relief, meaning these assets could be passed to your beneficiaries free from inheritance tax.
• Agricultural relief: If you own farmland or agricultural property, you could qualify for up to 100% relief.

These reliefs are available to encourage the continued operation of businesses and farms after the owner's death, but the eligibility criteria can be complex. It's crucial to get professional advice if you think you might qualify.

Use the Residence Nil-Rate Band

For many people, their home makes up much of their estate's value. Luckily, the UK government introduced the Residence Nil-Rate Band (RNRB) to provide additional inheritance tax relief when passing on a family home to direct descendants, such as children or grandchildren.

As of 2024, the RNRB allows an additional ￡175,000 per person to be passed on tax-free, on top of the standard ￡325,000 inheritance tax threshold. This means that a married couple can potentially pass on ￡1 million of their estate (including the value of their home) without paying inheritance tax.

The home must be passed to direct descendants to qualify, and the total estate must not exceed ￡2 million. If your estate exceeds ￡2 million, the RNRB begins to taper off, reducing the available allowance.

The Importance of Planning Ahead

Inheritance tax is often seen as a "death tax" that penalises families, but with careful planning, you can protect your estate and ensure that your loved ones aren't left with a significant tax bill. The earlier you start planning, the more opportunities you'll have to reduce your estate's value and take advantage of various allowances and reliefs.

Begin by assessing the value of your estate. Take stock of all your assets, including property, savings, investments, and personal possessions. Once you know the size of your estate, you can start implementing strategies to minimise inheritance tax.

Consider speaking to a financial adviser or planner if your estate exceeds the ￡325,000 threshold. They can help you navigate the complexities of inheritance tax and create a plan that meets your needs.

Conclusion

Inheritance tax doesn't have to be an unavoidable burden. By understanding the rules and taking proactive steps, you can significantly reduce the inheritance tax on your estate, ensuring that more of your wealth goes to the people who matter most. Whether through gift allowances, trusts, life insurance, or the various reliefs available, there are many options to help you protect your estate and your family's future.

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