Inheritance Tax Planning - Passing on Your Wealth
Most estates in the UK do not incur inheritance tax (IHT) as their value falls below the nil-rate band threshold.
Isn’t it only the wealthy who pay Inheritance Tax?
Death taxes were designed to provide revenue for the Treasury and, as a form of levelling up society, tax the wealthy.
There are numerous exemptions and reliefs that can be used to offset tax on an estate. Applying the reliefs and exemptions can result in a reduction of inheritance tax, often a substantial reduction.
Families that do not prepare for the possibility of tax being deducted from the value of their estate face having to pay a very large, unexpected bill from HMRC. Often higher than what the individual beneficiaries receive.
A large inheritance tax bill can arise from ignorance or an aversion to paying fees.
The wealthy can afford to make large gifts in their lifetime. They are very conscious of the amount of tax that will be taken from their estate and will seek out sophisticated advice.
Whereas uninformed and less wealthy people tend to be averse to paying fees, and simply ignore the financial impact on their estate.
IHT is Payable on Transfers of Value Out of an Estate
People often mistakenly think that inheritance tax applies upon death. That’s not quite true; it applies when transfers of value are made from your estate. It’s just that death forces a transfer of value to others.
Throughout their lifetime, individuals may have made several asset transfers. The cumulative impact of these transfers will accrue over their lifetime but will only be fully considered upon their death.
When you pass away, your assets must be transferred. If you have a legal will, it will be transferred to the beneficiaries you have nominated. If you have not left a will, then any transfer of assets will be governed by the law of intestacy, or with no living relatives passed to the crown.
Your estate will undergo a valuation before transferring any assets, property, or money. If its value surpasses the nil-rate band limit, your estate will be required to pay inheritance tax.
Monies will be deducted from the value of your estate to pay the inheritance tax due. This will lower the amount of value that will eventually pass to your beneficiaries. Your estate includes your money, possessions, and share of any property.
Presently, estates valued over £325,000 are liable to inheritance tax (IHT). Any amount exceeding this threshold, known as the “nil-rate band”, is taxed at a rate of 40%, unless it’s left to a surviving spouse. If that is the case, there is no immediate obligation to pay IHT.
The tax is applied to “UK domiciled individuals’” (those having the UK as their permanent home) worldwide assets. It also covers UK assets owned by foreign nationals.
Therefore, if you are a UK citizen, your foreign vacation property is still considered part of your estate for inheritance tax (IHT) purposes. In a similar vein, foreign nationals who own property or assets in the UK may be subject to inheritance tax in the UK if the total worth of their holdings exceeds £325,000.
The way taxes are treated varies depending on the specifics and changes in legislation, which might affect the amount paid in the future.
The Nil-Rate Bands
Inheritance tax has many regulations, exemptions, and reliefs, making it difficult to understand at times. However, knowledge of the nil-rate band is essential.
In essence, the nil-rate band is not exempt from tax, as many believe, but an allowance. The first £325,000 of your estate is taxed at 0%. Each person who could be liable for inheritance tax has a personal allowance of £325,000. Inheritance tax liability arises only when an individual’s estate surpasses this limit.
In some cases, this allowance may also be raised. For instance, an extra “residence nil-rate band” will be added if you bequeath your primary residence to a direct descendant upon your death.
The maximum residence nil rate band is fixed at £175,000 until 2028. This is on top of your current £325,000 nil-rate band. So before any IHT is due, the value of your estate may reach £500,000. However, the rules are very complex, so it is best to obtain advice from an experienced financial planner.
How does Inheritance Tax Work?
If you left an estate comprised of:
- £140,000 in savings, investments, and belongings
- Your home, valued at £440,000.
Your estate is worth £580,000 in total, which is more than the current combined nil rate band reliefs. If you have left your home to a direct descendant, then the level at which your estate will pay IHT will increase to £500,000 (£325,000 + £175,000). On that basis, IHT would be assessed on £80,000 and taxed at 40%.
No wonder that people seek advice from an experienced financial planner, for ways in which they could reduce the £32,000 tax bill.
It is essential that you consult with an experienced advisor who can look after your family with fresh eyes.
Contact us today and see how we can help you!
Inheritance Tax for Spouses in Marriage
As we’ve already seen, there are some significant advantages to marriage or a civil partnership when it comes to income tax.
If you are married or have a civil partner just the value of your share will be included in your estate if you co-own your property. In the example above, if you owned a 50% portion of the house, it would be worth £220,000. This means that, even after deducting your savings and belongings, you would still be within the nil-rate band, whoever received your estate.
You might decide to leave all your assets to your spouse, wife, or registered civil partner. If you do so, then inheritance will not be assessed on your estate. You’re essentially kicking the tax problem down the road, as your spouse will now have all your assets and, upon her passing, will be able to double the combined nil rate band reliefs.
There are several problems with this approach.
What if your spouse remarries and then makes a new will, leaving everything to her new partner? If she were to pass away later, will the surviving partner ensure that the children of the first marriage are financially provided for?
When estate planning is carried out, the financial planner must consider the wider implications of any planning and not only plan to reduce tax but also ensure that monies are passed securely to those you care for.
Gifting in your Lifetime
One of the most popular ways to avoid inheritance tax is to leave money or assets to your beneficiaries while you’re still living. But when it comes to giving and what you can offer, there are several guidelines.
In fact, when calculating your estate’s value, we include the entire value of:
- certain donations you made during the seven years leading up to your passing,
- or at any time if you continued to receive benefits from the gifted property afterward.
These are referred to as “gifts with a reservation of benefit”.
Typically, lifetime gifts fit into one of the three categories listed below:
Gifts that you can lawfully make at any moment without having to pay inheritance tax are known as exempt transfers. These consist of:
- Presents of any kind given to spouses or legal partners.
- Presents made up to £3,000 annually in each tax year.
- Regular disbursements from your taxable earnings. You can prevent the value of your estate from rising by making regular payments; you just need to prove that making regular gifts of this nature does not affect your standard of living. To assist the administrator of your estate, please document this very carefully, as you won’t be around to assist them.
- Gifts for the civil partnership or wedding ceremony (you can give your children £5,000, your grandkids £2,500, or anyone else £1,000)
- Small presents up to £250 annually for anyone (unless you have already made an exempt gift in that tax year to them).
- Contributions to national groups, political parties, or charities (gifts are tax-free both when made during your lifetime and when you leave money to charity in your will)
Direct Transfers of Value that Might be Exempt (PETs)
Potentially exempt transfers, or PETs, include gifts to people who are not on the list of people who cannot receive gifts, as well as gifts into certain types of trusts.
When you make the transfer, there is no inheritance tax due right away. However, if you pass away within seven years and the value of the PETs exceeds the nil rate band, IHT will apply.
Donations given less than three years prior to your passing will be subject to the full 40% tax rate. Donations given between three and seven years before death are subject to taper relief, a falling tax bracket.
For instance, suppose you gift £100,000 (known as a Potentially Exempt Transfer or PET) and then pass away within three years, leaving an estate valued at £300,000. In this case, the £100,000 PET becomes part of your estate (£400,000). Consequently, it would be liable for an IHT bill of £30,000 (40% of the amount exceeding the nil-rate band, specifically £75,000).
However, if you survive for more than seven years after making the PET, your estate will not include the value of the gift upon your passing. In this situation, there would be no inheritance tax due on the gift.
How to Avoid Paying Inheritance Tax using Trusts
Indirect transfers of value (chargeable lifetime transfers)
When you transfer assets into a flexible or discretionary trust, like the one we mentioned, we call it a chargeable lifetime transfer (CLT). This is because it doesn’t entail giving a gift directly to a particular beneficiary.
When you give a gift to a trust that falls below the nil-rate band, there’s no immediate tax obligation. However, it’s crucial to remember that inheritance tax is assessed cumulatively. Therefore, it’s important to take into account all non-exempt gifts you’ve made over the past 7 years to determine your tax liability.
It is possible to:
- gift up to the nil rate band into trust,
- wait seven years, and then make a further gift of the same amount with no chargeable lifetime tax to pay.
There will be a tax charge of 20% on the excess amount if the CLT, when added to the total number of CLTs in the previous seven years, exceeds the nil rate band. Consequently, many individuals who wish to gift substantial sums of money often opt to gift up to the threshold’s value (currently £325,000) to a trust. And then make further gifts into something other than a trust.
If you live for at least seven years after the date of the chargeable lifetime transfer (CLT), these transfers will typically not be counted as part of your estate for inheritance tax (IHT) purposes. Conversely, if you pass away within seven years of making the chargeable lifetime transfer (CLT), its value will be included in your estate. That would mean your estate is paying the other 20% of the balance due.
Things to Consider Before Making Chargeable Lifetime Transfers:
Once you make a gift, it is no longer your money. Don’t gift money that you may require later in life; your forward planning needs to take into consideration all manner of possibilities. If there is a possibility that you may require the return of your capital at some point, then arrange a loan. If you plan to do so, please ensure that any arrangement is carefully drafted.
You can Make a Loan Directly, or You can Arrange It via a Loan Trust:
If you are considering lending money to your children to enable them to get a step on the housing ladder, then do remember that this is a highly emotional decision, so be cautious. Make sure you clearly document the transaction as a loan to your child.
Sooner or later, your child will have a partner move in with them. You may not get along with their partner. If you have not clearly documented it as a loan, then if there is a falling out, by law, the onus is on you to prove that it was a loan, not a gift.