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A guide to inheritance tax

  • 11 May 2021
  • 10 minutes

Handing over cash, property and assets to loved ones can offer a much-needed boost to grown-up children moving up the property ladder or even to grandchildren saving for their first home. It can also be a very tax efficient way of reducing the size of your estate for inheritance tax (IHT) purposes.

Yet our Family and Finances report, which surveyed more than 1,000 parents over the age of 60, lays bare the gap in financial planning when it comes to passing on wealth.

Our research has highlighted the difficulties many families have when it comes to talking about their future finances, with some 43% admitting they never discuss later life planning with their children. And an overwhelming majority, 78%, have no estate planning strategy in place.

This means that there is limited understanding of inheritance tax and how it can impact passing on wealth to the next generation. When asked to rate their understanding of the taxes often associated with estate planning, 24% of our respondents said they were aware of inheritance tax (IHT) but knew nothing about it.

Read more about the research in our Family and Finances Report.

So, here are some things about IHT and gifting to your family that you might not know about.

Your inheritance tax liability depends on your individual circumstances. Your circumstances, and UK tax rules, may change in the future.

What is inheritance tax?

Inheritance tax is the tax on the estate of a person that has passed away. The word estate sounds grand, but essentially this covers money, possessions and property. Collectively, these are known as your assets.

How much is it?

The standard rate of inheritance tax is set at 40%. The threshold is £325,000. So, if your estate is worth less than this amount (known as being below the nil-rate band), then there will be no tax for your family to pay when you die.

This amount is set by the Government and is called the nil-rate band, because it’s the amount you pay a ‘nil-rate’ of IHT on. It can be compared to income tax whereby you only pay tax above your personal allowance.

Married couples and civil partners can inherit their spouse's entire estate tax free. They can also now add any of their spouse’s unused IHT allowance to their own to increase the potential nil-rate band of their estate.

If none of the first spouse’s tax free allowance is claimed, this means a couple can effectively pass on £650,000 before inheritance tax has to be considered.

A special exemption: your main residence

Following reforms announced by former chancellor George Osborne in 2015, it is also now possible for parents to pass on a home worth up to £1 million to their children tax free since April 2020. This is as a result of the residence nil rate band which is currently £175,000 (plus the nil-rate band of £325,000) meaning that each parent can pass on up to £500,000 each.

To be eligible for the residence nil rate band the property must be your main home (i.e. it does not apply to buy-to-lets or holiday homes) and only applies where you are leaving your property to “direct descendants”.

Read more: Intergenerational wealth transfer: It’s all the rage

Gifting your pensions

Not many people realise that pensions, or defined contribution employer pensions, can be passed on to your spouse, children or grandchildren tax free. But only if you die before reaching the age of 75.

Beneficiaries could receive either a lump sum on your death or they can inherit your drawdown plan as regular income. An option called ‘inherited drawdown’ allows your beneficiaries to take out as much or as little as they need, when they need it, without having to wait until they retire.

If you die after the age of 75, your pension provider will deduct income tax from anything your legatees take.

The key thing to remember is to nominate who should benefit. Speak to your pension provider as passing on your pension is an entirely separate arrangement to the rest of your estate.

Exempt gifts

Gifts between spouses or civil partners living in the UK are exempt from IHT, either during life or on death.

For other family members and even those outside the family, you can gift up to £3,000 a year and it is immediately exempt from inheritance tax under the “annual exemption” rules. If you didn’t make a gift of this kind in one tax year you can carry it forward to gift £6,000 in the following year.

So, a married couple giving for the first time could hand over £12,000 to their children in one year. After that, the maximum would be £6,000 each year per couple.

Each parent can also give £5,000 to their children as a gift for their wedding or civil partnership. Grandparents and great-grandparents can each give the couple £2,500, and other relatives or friends, £1,000.

Lastly, you can give £250 to any number of people every year, but you cannot combine it with your annual £3,000 exemption.

On all counts, it’s vital you keep a record of all the gifts you make and who received them to avoid confusion in the future.

Gifts between spouses or civil partners living in the UK are exempt from IHT, either during life or on death.

One of the most useful but surprisingly under-utilised exemptions is the ‘gifts from normal expenditure’ rule.

This allows you to gift any amount of surplus income above that necessary for you to maintain your normal lifestyle, without it being included in your IHT. To be eligible, the gift has to be regular in nature (monthly, bi-annually, annually or at specific dates such as birthdays) and records of your income and expenditure for each tax year should be maintained to show it was surplus income and NOT capital.

For example if you could show that you managed to save £10,000 a year from your income, you could start gifting this £10,000 to your children instead. Again, record-keeping is a must.

Gifting capital: the seven-year rule

Most gifts in excess of these exceptions are classed as Potentially Exempt Transfers (PET) which means there is no tax charge at the time of gifting, and provided you survive for seven years there shouldn’t be any liability to inheritance tax on your death. But if you don’t survive for seven years, then it’s not just the value of that gift which will be added back into your estate but any gifts you made in the preceding seven years BEFORE that gift also need to be considered. So potentially, a period of up to fourteen years.

Taper relief

If you do pass away within seven years of making a capital gift AND inheritance tax is payable on your estate, then depending on when you made that gift the inheritance tax payable could be reduced. The rules around this are complicated and you should seek specialist tax advice when considering making any gifts.

Gifting your home

As we’ve seen, most people’s main residence now falls outside of IHT. But rather than waiting until you die, you might want to hand over your property before your death. Again, provided you survive the gift by seven years, there’s no IHT to pay.

But, it has to be an outright gift from which you no longer benefit. If this is your main residence, continuing to live there would essentially delay the start of the seven-year clock.

But if you decided to retire to a holiday home or what was previously a buy-to-let property, then you will satisfy the rules.

A word of caution: if you need to go into long-term care local authorities will want to know of any major gifts you may have made to assess whether you could have deliberately deprived yourself of assets to avoid paying for fees. Some have been known to go back twenty years to recover significant gifts.

Read more: The role of trusts in estate planning

The importance of a will

If you die without making a will – known as intestacy – you could leave your heirs with a major headache trying to sort out your estate. Writing a will not only means you can detail exactly how you would like your assets to be distributed after your death, it can also be used to help reduce your tax bill.

Using a solicitor to draw up your will ensures that your legacy is structured correctly and getting professional advice on tax planning can ensure your will is as tax-efficient as possible.

Depending on the size of your potential estate and any gifts already made during your lifetime, they might also suggest setting up a trust to manage your legacy.

If you already have a will, it’s worth revisiting it regularly. You might need to do so to benefit from the new residence nil-rate band, for example.

Read more: Giving financial help to those you care about

It’s time to talk

One clear theme from our Family and Finances Report is that there seems to be reluctance to discuss estate planning and the passing on of wealth with children.

Some 65% of those surveyed said they rarely or never discuss inheritance with their children. Of the fifth (22%) that do have an estate plan in place, less than half (48%) say their children know exactly what the plan is.

One in 10 (11%) say they’ve never spoken to their children about their plans in place. When asked why 32% cited that they “don’t think it’s their business to know about my finances” while 30% said they wanted their children to be financially independent. Some 13% admitted they don’t feel comfortable talking about money with their children.

But as we get older, it’s vital to consider inheritance tax, and take sensible steps to maximise our potential legacies and to make sure our loved ones are aware of our wishes.

The need for estate planning is becoming increasingly common as rising house prices push up the total value of people’s net wealth. While it was intended to be a tax on only the very wealthiest estates, the freezing of the inheritance tax threshold for a decade has meant that many more people have been caught in its net.

But inheritance tax planning is complex because of the countless considerations you need to take into account. These include the size of your estate, your health, what you can afford to give away, and what you might need in the future.

Even the government is aware that the rules around leaving and inheriting an estate are complex. A review by the Office of Tax Simplification (OTS) resulted in a number of recommendations designed to simplify the IHT process for those left behind after a loved one dies.

Taking professional advice on tax and estate planning could prove to be money well spent. It can help you make sure your wishes are respected, and provide peace of mind that your heirs can inherit your estate in the most tax-efficient manner.

But remember it’s absolutely crucial not to leave yourself short of money you might need to fund your lifestyle and potential future care costs just to save on tax bills.

Important information

Any views expressed are our in-house views as at the time of publishing.

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In preparing this article we may have used third party sources which we believe to be true and accurate as at the date of writing. However, we can give no assurances or warranty regarding the accuracy, currency or applicability of any of the content in relation to specific situations and particular circumstances.

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