Introductory Guide to IHT

Our recent article on gifting (see here) cleared up a specific misconception surrounding how much you can gift to your loved ones free of inheritance tax [IHT].

Here we take a step backwards and consider IHT more broadly, what it is, what’s taxable, what’s not and how to estimate the potential tax bill.

Although IHT accounts are still a relatively small proportion of total UK tax receipts, it’s still significant and rising as we saw from our earlier post (here).

In the past, the view was that IHT was only ever paid by the very wealthy. Rising property prices however have pulled many more into the IHT net. It is now this “new wealth” that pay a disproportionate amount of their estate in tax, while the “old wealth” continue to use sound planning strategies to avoid it.

You’ve worked hard all your life to get where you are. With careful planning, the tax bill faced by your loved ones could be considerably smaller. We will cover planning strategies in later articles, but first, let’s find out if you are affected.

Key points

• IHT is payable on death and on certain lifetime gifts

• Estates are entitled to a nil rate band [NRB] of £325,000. Unused NRB can be transferred to a spouse

• An additional NRB, the Residence Nil rate Band [RNRB] is available where residential property is passed on death to direct descendants. Unused RNRB can also be transferred to a spouse

• Lifetime gifts may be subject to IHT if the donor dies within seven years of making the gift (subject to what I set out previously)

• Gifts to certain trusts may be a chargeable lifetime transfer (CLT) and IHT at 20% may be charged if the amount gifted into trusts exceeds the available nil rate band.

• On death, IHT is payable at 40% on the value of the estate less liabilities

What is IHT?

IHT is a tax that may be payable on your 'estate' when you die.

It can also apply to certain gifts made during your lifetime.

Broadly, IHT will be due if the value of your estate on death is greater than your 'nil rate band' [NRB].

The standard NRB is £325,000, although the amount available to you could be different depending on individual circumstances. If your estate on death is greater than your nil rate band, the excess is typically taxed at 40%.

Example Your estate on death is worth £500,000 and your nil rate band is £325,000. The inheritance tax charged will be 40% of £175,000 (£500,000 LESS £325,000).

What is included in your estate?

If you consider your home to be the UK, your estate for tax purposes will be the value of all the assets you own anywhere in the world. This includes your family home, buy to let properties, cars, savings, investments and personal possessions.

Your estate on death could also include gifts you made in the seven years before your death. Any liabilities, such as money owed, will reduce the value of your estate.

Pension savings are not, however, normally included in your estate. That's because your pension provider will usually decide where any remaining funds are paid, and not your executors. You will, of course, be able to tell your provider who you wish to benefit.

Exempt assets

There will be no IHT on certain assets in your estate. These include:

• assets gifted to your spouse or civil partner

• assets gifted to charity

• business assets, such as shares in a family business, or other 'unlisted' shares, which you have owned for at least two years (I will post an article on this shortly)

• agricultural property, such as land used for farming and the farmhouse situated on that land

After these reliefs and exemptions have been deducted, the remaining estate over your NRB is taxed at 40%.

Nil Rate Bands [NRBs]

Your personal NRB

This is currently £325,000, and is fixed at this amount until April 2026. Any gifts made in the seven years before your death will use the nil rate band first, with the balance available to set against your estate.

Transferable NRB

If your spouse or civil partner died before you, your executors can claim the unused part of your partner's £325,000 NRB. If your spouse left everything to you when they died, you could have up to £650,000 to set against your estate. But money left to others, such as children or grandchildren, can reduce, or wipe out, the amount that can be transferred.

Example If your spouse died and gifted half of his nil rate band to your children and everything else to you, you will be able to claim the 'unused' part of his NRB (i.e. 50%), giving you a band of £487,500 at current levels (£325,000 + £162,500).

Residence Nil Rate Band

There is an additional £175,000 of NRB which can be claimed if the family home passes to direct descendants (children, grandchildren etc.) on death, the Residence Nil Rate Band. Just like the main NRB you can also claim any unused part of the allowance from your spouse or civil partner if they died before you.

The RNRB has been fixed at £175,000 until April 2026.

This means that individuals could be paying no tax on the first £500,000 of their assets, rising to £1M if they are able to claim unused bands from their deceased partners.

Example Alan and Jean owned their home jointly. On Alan's death Jean inherited his share of the family home and his will also left all his other assets to Jean. Alan has not used his nil rate band of £325,000. His residence nil rate band has not been used as the family home did not pass to direct descendants. Jean's estate can claim both Alan's unused nil rate band and residence nil rate band. If Jean's estate is to be split between her children Mark and Steven she would have the following nil rate bands; Main nil rate band £650,000 (2 x £325,000) Residence nil rate band £350,000 (2 x £175,000) The residence nil rate band can still be claimed if you no longer own property on your death. This is to allow anyone that needed to sell the home to claim. This could be to go into residential care or move in with relatives or to downsize to a smaller property. However, the additional nil rate band begins to be withdrawn for anyone with assets of more than £2M.

Lifetime Gifts

Those who can afford to make gifts during their lifetime can significantly reduce the amount of IHT payable on their estate. A gift you make during your lifetime will not be included in your estate if you are still alive after seven years.

For tax purposes there are four types of lifetime gift;

Potentially exempt transfers (PETs)

The most common type of lifetime gift is an outright gift to an individual. There will be no immediate charge to tax whatever the value of the gift. And it will be completely free of IHT provided you survive it by seven years.

If you did die within this period, however, the value of the gift when made becomes chargeable and is included in to your estate to work out how much IHT is due.

To decide who actually pays IHT, your nil rate band will be allocated to your lifetime gifts first, with any balance used against the assets in your estate at the date of death.

If the value of your lifetime transfers in the seven years prior to your death is less than your nil rate band, then no tax is due on them. But this will mean that more of your estate will be taxable at 40%.

If the value of your lifetime transfers in the seven years prior to your death is greater than your nil rate band, there will be tax to pay on these gifts at 40% on the excess, and this tax should be paid by the person to whom the gift was made. The tax bill can be reduced by 'taper relief', but to claim this the donor must have survived the gift by at least three years. This will also mean that there is no nil rate band left for the estate, and so it will all be taxable at 40%.

Chargeable lifetime transfers (CLTs)

Chargeable lifetime transfers are different to PETs because if they are large enough there could be an immediate tax charge. CLTs are typically gifts into certain trusts (interest in possession trusts and discretionary trusts).

If you make a gift of more than your available nil rate band (while you are alive, this will not include the residence nil rate band or the unused band of a deceased spouse), an immediate 20% IHT charge is made on the excess.

Example James gifts £400,000 into a discretionary trust. There will be a 20% IHT charge on the amount over the available nil rate band. (£400,000 - £325,000) x 20% = £15,000 IHT due by the trustees

The remaining taxation is very similar to a PET. There will be no further tax to pay if you survive for seven years. And the value of the gift is added back in to your estate if you die within seven years and taxed at 40% if in excess of the nil rate band. Taper relief is again available to reduce any tax payable. And any tax paid at 20% when the gift was made can be used to offset tax payable on death.

Example (Continued) If James died four years after making the gift, further IHT may be payable. Assuming the nil rate band at death remains at £325,000. IHT at the full rate (£400,000 - £325,000) x 40% = £30,000 IHT reduced by taper relief (£30,000 x 60%*) = £18,000 Less IHT already paid = £15,000 So trustees have a further £3,000 to pay. (£18,000 - £15,000) *If an individual dies between four and five years after making a gift, only 60% of the full IHT liability is payable.

Exempt Gifts

Gifts to your spouse or civil partner are free from IHT, as are gifts to charities.

You can also give away up to £3,000 each tax year to whoever you chose without it counting towards your estate if you die. And if you haven't used your annual gifting exemption you can go back and claim an extra £3,000 from the previous tax year allowing an IHT free gift of up to £6,000.

It is also possible to make regular gifts out of your income which will be immediately outside your estate. There is no limit on the size of the gifts provided you have sufficient surplus income from which to make them.

Gifts With Reservation

If you continue to benefit from any gifts you make they will not be effective for IHT. For example, if you gave your home to your children but continued to live there rent free this would be a gift with reservation and the market value of the property would remain in your estate.

Calculating the IHT due on death

On death the value of your estate is the total of all your assets less your liabilities, such as any outstanding tax or loans which must be repaid. Added to this will be any PETs or CLTs made in the seven years before death.

There's no IHT payable on any part of your estate which is paid to your spouse/civil partner or is paid to charity. Business property relief can mean certain assets related to a trading company, such as shares in business, are free of IHT. A similar relief applies to certain agricultural property.

Inheritance tax is chargeable at 40% if the total assets not covered by these exemptions are greater than the nil rate band. This will include any transferable nil rate band or residence nil rate band of a deceased spouse or civil partner. PETs and CLTs will have first use of the standard nil rate band in the order in which they were made.

Who is liable to pay the tax depends upon what part of the estate is subject to IHT:

• a failed PET - tax is payable by the recipient of the gift

• a failed CLT - tax is payable by the trustees of the lifetime trust.

Any tax payable at 20% when the gift was made can be offset against the tax due on death

• your estate - tax is payable by your executors

The rate of IHT is reduced to 36% where gifts to charity exceed 10% of the value of the estate.

Example IHT calculation George died in May 2021 leaving an estate of £1,000,000 which all passed to his children. His estate included the family home valued at £400,000. George was a widower and his wife Brenda used 50% of her NRB on her death. Before his death George made the following gifts: May 2007 - £100,000 to son Jim July 2015 - £250,000 into a discretionary trust June 2016 - £100,000 to daughter Kim George's IHT liability George's nil rate band will be (£325,000 x 150%) £487,500 He will have a residence nil rate band of (£175,000 x 2) £350,000 His total nil rate band will be £837,500 May 2007 gift is not included within the estate as it was made more than seven years before death. July 2015 and June 2016 gifts are both within the increased NRB and will use £350,000 of NRB. Remaining nil rate band available against the estate (£837,500 - £350,000) £487,500. Total Estate £1,000,000 Remaining nil rate band (£837,500 - £350,000) £487,500 Taxable estate (£1,000,000 - £487,500) £512,500 IHT payable £512,500 x 40% £205,000

Paying the tax

IHT is normally payable six months after the end of the month in which death occurred. In certain circumstances IHT can be paid in instalments. Grant of Probate entitling your executors to access and distribute your property cannot be obtained until after IHT has been paid.

Estate IHT Analysis

If you are concerned about IHT and would like a report which summarises your likely liability plus potential planning opportunities please get in touch.