Inheritance Tax can be a complex topic, but it’s an essential consideration for anyone wanting to ensure their wealth passes to their loved ones as smoothly as possible.
Regardless of whether you live inside or outside of the UK, you likely know about the impact inheritance tax in the UK might have on your future finances. Fortunately, inheritance tax in the UK only affects a proportionally small number of estates, so there’s a good chance you won’t be impacted by it.
However, if you are set to inherit the estate of a close relative who has passed away, and their estate falls into the taxable category, then it can be useful to know how inheritance laws work so you can avoid paying unnecessary fees.
In this article, we’ll demystify inheritance Tax, explaining the key concepts in simple terms and offering practical steps you can consider when financial planning.
At Baggette + Co Wealth Management, we understand the intricacies of Inheritance Tax and can provide experienced guidance.
What Is Inheritance Tax?
In short, inheritance tax is a tax paid on either death or a lifetime transfer out of an estate. It is a tax on the estate of someone who has passed away, or in the case of a lifetime transfer when a gift is made over the nil rate band – currently £325,000. An estate includes all the property, money, and possessions of the deceased.
In the UK, IHT is often referred to as a “death duty,” though it is not levied on every estate.
What falls under an estate can include, but is not limited to, the following:
- Money
- Pensions
- Shares and investments
- Property
- Land
- Personal possessions
- Insurance pay-outs
- Jointly owned assets
There are two main bands that can be used to offset IHT, these are the Nil Rate Band (£325,000) and the Residence Nil Rate Band (£175,000); these bands are currently frozen until April 2030. So, if your estate is worth over £1,000,000 for couples, then it may be worth continuing to read.
Without careful planning, a significant portion of your estate may be subject to tax, potentially reducing the amount passed on to your loved ones. It affects beneficiaries who receive an inheritance. In many cases, it can place a financial burden on families if they need to sell assets to pay the tax liability.
The standard Inheritance Tax rate is 40%. This applies to the portion of your estate that exceeds the nil-rate band.
As IHT is levied at 40% on the value above any allowances, it can very quickly erode real value from any inheritance.
Understanding IHT is crucial for effective estate planning, ensuring your assets are distributed according to your wishes while minimising the tax burden on your loved ones
Why Do You Pay Inheritance Tax In The UK?
The main idea behind the tax is to prevent the accumulation of wealth upon the death of an individual. Instead, some of the wealth is redistributed to the state, ensuring that it can be directed towards projects and services that benefit everyone in the country.
What Is the Inheritance Tax Threshold (Nil-Rate Band)?
Well, fortunately, there are two bands when it comes to inheritance tax – the IHT threshold (known as the nil-rate band) is £325,000. This is the amount of your estate that you can pass on tax-free. The inheritance tax nil-rate band in the 2024/25 tax year is £325,000. This means that no IHT will be due on the first £325,000 of your estate when you die, regardless of who you leave it to.
As with many taxes, there are a variety of rates that can be applied to inheritance tax. In the UK, the base rate of this tax is set at 40%, which applies to the value of an estate exceeding the inheritance tax allowance, regardless of the contents of the estate in question.
However, the good news is that this percentage rate can taper off for lifetime gifts made within seven years before the owner of the estate’s death, eventually disappearing entirely after seven years. This reduction is known as taper relief, which applies only to the IHT payable on gifts that exceed the available inheritance tax nil-rate band.
Below are the different percentage rates based on the time elapsed between the gift and the donor’s death:
Period of time between gift and death Effective Tax rate
Less than 3 years 40%
3 to 4 year 32%
4 to 5 years 24%
5 to 6 years 16%
6 to 7 years 8%
7 or more years 0%
It’s important to note that taper relief reduces the tax payable on the gift, not the value of the gift itself. For example, if a gift made three to four years before death exceeds the nil-rate band, the tax rate on that gift would be reduced to 32%, rather than the full 40%.
Additional allowances include the Residence Nil-Rate Band (RNRB), which provides up to £175,000 for passing a main residence to direct descendants, potentially increasing the total threshold to £500,000 per individual. For married couples or civil partners, unused allowances on first death can be transferred to a surviving spouse/civil partner for their estate to claim on second death, doubling the combined threshold to £1 million if applicable.
However, the RNRB is tapered for estates valued over £2 million. For every £2 above this threshold, the RNRB is reduced by £1. This means that estates valued significantly above £2 million may lose the RNRB entirely. Meaning it is reduced quickly, especially when pensions will potentially form parts of estates from April 2027.
How to Value an Estate for Inheritance Tax (IHT)
Valuing an estate for Inheritance Tax (IHT) doesn’t have to feel overwhelming. Let’s explore the process through Emma’s story, a real-world scenario that highlights the key considerations when assessing an estate for IHT.
Emma’s Story: Understanding IHT
Emma was a widow who had worked hard to create a legacy for her two children. Her estate, valued at £1,200,000, included her family home, savings, and investments. Like many, she wanted to ensure her children could inherit as much as possible, but she knew IHT would apply. Here’s how her estate was assessed.
1. Valuing the Estate
Emma’s estate consisted of:
- A home worth £800,000.
- Savings and investments totalling £400,000.
These assets combined gave her estate a value of £1,200,000.
2. Considering Liabilities
Emma had no outstanding debts or loans, and funeral expenses had already been accounted for. This meant the full value of her estate would be subject to IHT calculations.
3. Applying Tax-Free Allowances
Emma’s estate benefited from two key allowances:
- The Nil-Rate Band (NRB): A standard allowance of £325,000 available to all estates.
- The Residence Nil-Rate Band (RNRB): An additional £175,000 because Emma left her home to her children, who are direct descendants.
Combined, these allowances totalled £500,000, reducing the taxable portion of her estate to £700,000.
4. Calculating IHT
Inheritance Tax is charged at 40% on the taxable estate. For Emma:
- Taxable estate = £1,200,000 – £500,000 = £700,000.
- IHT liability = £700,000 × 40% = £280,000.
This meant Emma’s children would need to pay £280,000 in IHT before the remaining estate could be passed on.
The above does not include the £3,000 per year allowance for gifting from capital during the lifetime.
5. What About Pensions and Inheritance Tax?
In Emma’s case, her pension wasn’t included in the estate valuation because it had been set up to pass directly to her children. Depending on how pensions are structured, they may fall outside the IHT calculation, offering a way to preserve more wealth for loved ones. Note, however, that there is proposed legislation effective April 2027 that inherited pensions will form part of the estate.
6. A Lesson in Estate Planning
Emma’s story is a powerful reminder of the importance of financial planning. By understanding how her estate was valued and taxed, she was able to take proactive steps to protect her legacy. With the help of a financial adviser, she explored options to minimise the IHT burden and ensure her children could inherit as much as possible.
If you’re wondering how to value your estate or reduce your IHT liability, seeking advice can make all the difference. A little financial planning today ensures your legacy is passed on the way you intend.
Who Pays Inheritance Tax and When Do You Pay?
Inheritance Tax (IHT) is paid by the deceased’s estate, and it’s usually the responsibility of the executors of the will—or the administrator if there’s no will.
The executors need to value the estate, figure out how much IHT is due, and make sure it’s paid to HMRC. Here’s the tricky part: if they don’t handle it properly, they can be held personally liable. So, it’s really important to get everything right.
IHT needs to be paid within six months of the person’s death. If it’s late, HMRC charges interest, and that can be a problem if things like property need to be sold to cover the bill.
You are able to make annual instalments over 10 years to cover this debt, especially if the items take a while to sell.
If this sounds overwhelming, it’s a good idea to speak to a qualified independent financial adviser or a solicitor. They can guide you through the process, help with financial planning, and even look at ways to reduce the IHT bill in the first place. It’s always better to plan ahead when you can.
Inheritance Tax on Gifts
This is an area where many people can significantly reduce (or inadvertently increase!) their Inheritance Tax (IHT) liability.
There are three main types of gifts:
- Exempt Transfers: These include gifts between spouses or civil partners or gifts made regularly from surplus income without affecting your standard of living.
- Potentially Exempt Transfers (PETs): These gifts, such as cash or property given to individuals, become IHT-exemptif you survive seven years. If you pass within seven years, the gift may be taxed, but transitional relief could apply.
- Chargeable Lifetime Transfers (CLTs): Larger gifts, often into trusts, where 20% tax is charged immediately on amounts over the Nil-Rate Band (£325,000). The seven-year rule still applies here.
Note: we have not included the £3,000 annual gifting from capital.
If you set up a trust and transfer £325,000 into it, and you survive seven years, the amount moves out of your estate and becomes exempt from IHT. However, if you pass within the seven years, taper relief rules apply, and part or all of the gift may still be taxable.
One of the easiest ways to move assets outside your estate is by gifting via surplus income (e.g., pensions or salary). These gifts are exempt, provided they don’t reduce your standard of living. Make sure to keep clear records of these gifts to avoid disputes during probate.
Chargeable Lifetime Transfers (CLTs), on the other hand, can get complex. These larger gifts, either into a trust are taxed at 20% on amounts over £325,000 immediately, with the seven-year rule still in play. Given the complexities, it’s always advisable to seek professional guidance before proceeding.
Lastly, remember that when making gifts, you are responsible for any IHT due, not the recipient. However, if the donor fails to survive 7 years, then the responsibility falls on the recipient. This can either be taxed at source or paid separately. It’s important to get this right to avoid any future complications.
If you’re unsure about gifting or how it impacts your estate, have a chat with an independent financial adviser or solicitor to help navigate this process as part of your overall financial planning.
Probate and Inheritance Tax
Probate is the legal process of managing a deceased person’s estate, which includes distributing assets to beneficiaries and settling any outstanding debts. To carry out these duties, you’ll typically need to obtain a Grant of Representation. This legal document authorises you to act as an executor (if there is a Will) or administrator (if there isn’t one).
A critical point to keep in mind is that Inheritance Tax (IHT) often needs to be paid before the Grant of Representation is issued. This can create challenges if the estate’s assets aren’t easily accessible, such as when funds are tied up in property.
This is why early estate planning is so important. Proper planning can help ensure funds are available to settle IHT promptly, avoiding delays or complications during the probate process. Consulting with a solicitor or independent financial adviser can make navigating probate and IHT much smoother and more efficient.
Using Trusts to Reduce Inheritance Tax
Trusts are a powerful tool for managing assets and can help reduce Inheritance Tax (IHT) liabilities. By placing assets into a trust, they are no longer considered part of your estate for IHT purposes after seven years, provided the transfer qualifies.
Assets held in trusts can pass to beneficiaries without attracting the standard 40% IHT charge on estates above the £325,000 nil-rate band.
For example, imagine you place £500,000 into a discretionary trust, assuming your whole nil rate band is available, then £175,000 (£500,000-£325,000) would be immediately charged the lifetime rate of IHT of 20% (£35,000).
If you survive seven years, the £500,000 is fully outside your estate for IHT purposes, potentially saving up to £200,000 in tax (40% of £500,000). Even if you pass away within seven years, taper relief may reduce the IHT charge after the third year.
Commonly used trusts include:
- Discretionary Trusts: These provide flexibility, allowing trustees to decide how and when beneficiaries receive assets. This can be ideal for complex family arrangements or safeguarding wealth for future generations. These are subject to exit and potentially periodic charges.
- Bare Trusts: Beneficiaries have an immediate and fixed entitlement to the trust assets, which can be tax-efficient for gifts to minors as income and gains may be taxed at the child’s lower rates subject to parental settlement rules.
By using trusts, you can protect family wealth, manage asset distribution, and reduce the IHT burden on your estate. It’s a valuable tool in financial planning, and seeking advice from a solicitor or independent financial adviser ensures trusts are structured and managed effectively.
Equity Release/Lifetime Mortgages and Inheritance Tax
A Lifetime Mortgage allows homeowners to access the value tied up in their property, providing a useful strategy for managing Inheritance Tax (IHT).
- Paying IHT: The funds released through Lifetime Mortgages can be used to cover IHT bills, avoiding the need to sell other valuable assets such as investments or family heirlooms.
- Reducing Liabilities: Gifting the released equity to beneficiaries and surviving for seven years removes the gifted amount from your estate, potentially saving 40% in IHT. For example, gifting £100,000 could save £40,000 in tax if you survive the required period.
Another common use of an Equity Release/Lifetime Mortgage is to fund current living expenses. If your estate is above the IHT threshold, spending some of the money now effectively reduces the size of your estate, lowering your future IHT liability.
An Equity Release/Lifetime Mortgage can be a valuable tool in financial planning, but it’s essential to seek advice from a solicitor or independent financial adviser to ensure it fits your circumstances and long-term goals.
Using equity in your home will affect the amount you are able to leave as an inheritance.
Any means-tested state benefits (both current and future) may be affected by any Lifetime Mortgage. This is a lifetime mortgage. To understand the features and risks, ask for a personalised illustration.
Using Life Insurance to Pay Inheritance Tax
Life insurance can be a simple and effective way to ensure your Inheritance Tax (IHT) liabilities are covered. A policy can provide a tax-free lump sum to your beneficiaries, allowing them to settle any IHT due without the need to sell assets such as property, investments, or heirlooms.
To maximise the benefits of life insurance for IHT purposes, consider placing the policy in a trust. By doing so:
- The payout is kept outside your estate, ensuring it doesn’t attract additional IHT.
- The funds are paid directly to your trustees, ensuring quick access when the IHT bill is due.
Using life insurance in this way safeguards your estate, ensures your loved ones have the resources they need, and provides peace of mind during a challenging time. It’s a straightforward solution that can be an integral part of effective financial planning, and it’s essential to seek advice from a solicitor or independent financial adviser to ensure it fits your circumstances and long-term goals.
How Do I Prepare for Inheritance Tax?
Preparing for Inheritance Tax (IHT) can feel daunting, but with a clear plan, it’s entirely manageable. The first step is to understand the value of your estate. Having a clear picture of your assets, liabilities, and how they are structured is the foundation of effective IHT planning.
Another key step is ensuring your Will is up to date. A well-structured Will not only reflects your current wishes but also help ensure your estate is distributed in a tax-efficient way. Reviewing and revising your Will regularly can make a significant difference in managing your IHT liabilities.
It’s also important to explore tax-efficient strategies. This could include gifting, using trusts, or other approaches discussed in this blog, all of which are critical in achieving a positive outcome.
Given the complexities of IHT, seeking professional advice is one of the most effective steps you can take. An experienced independent financial adviser can work with you to create a personalised plan tailored to your unique needs and circumstances.
Finally, start early. The sooner you begin planning, the more options you’ll have to protect your assets and minimise IHT.
Contact our Independent Financial Advisers in Dorset
If you’re ready to take control of your inheritance tax planning, we’re here to help. At Baggette + Co., we specialise in helping families navigate the intricacies of IHT, ensuring their assets are passed on with care and efficiency. Get in touch today, and let’s create a plan to secure your legacy.
If you have questions about inheritance tax planning, our experienced independent financial advisers in Dorset and Hampshire are ready to assist you with advice and strategies tailored to your specific needs.
Contact Oscar Hjalmas, our CEO and independent financial adviser, on 01202 676983 or email advice@baggette.co.uk to arrange a consultation.
Baggette + Co Wealth Management is authorised and regulated by the Financial Conduct Authority. The Financial Conduct Authority does not regulate estate planning, tax advice, will writing or trusts. The above information is correct to the best of our understanding as at the date of publication. Nothing within this content is intended as, or can be relied upon, as financial advice. Capital is at risk. You may get back less than you invested. Tax rules may change, and the value of tax reliefs depends on your individual circumstances.