You may think “Inheritance Tax? That’s just for rich people, isn’t it?”. You would be wrong. As we’ll see in this retiree’s guide to Inheritance Tax, rising house prices and frozen reliefs mean that you could face a tax bill of thousands of pounds.
In fact, according to HM Revenue & Customs, receipts from Inheritance Tax reached a record high between April and June 2022.
We’ll look at how Inheritance Tax (“IHT”) is calculated and, crucially, how you can avoid it.
If you want to avoid paying substantial sums to HM Revenue & Customs rather than to your loved ones, read on.
1. How to calculate Inheritance Tax
So, the first step in our retiree’s guide to Inheritance Tax is to actually calculate our potential IHT liability.
After all, if there is no IHT liability then there is no point in planning how to avoid it!
Also, if you are applying for probate then you will need to calculate any IHT.
1.1 What is Inheritance Tax?
The simple definition
IHT is tax on the value of everything that a person owns when they die.
The technical definition
The legislation (Inheritance Tax Act 1984) defines IHT as being “… charged on the value transferred by a chargeable transfer.”.
UK tax legislation often defines things by saying what they are not. In this case, a chargeable transfer is defined as a transfer, made by an individual, other than an exempt transfer (more on this later).
These chargeable transfers of value are primarily associated with the transfer which takes place on the death of the individual. However, note that in certain circumstances IHT may be payable on lifetime transfers.
IHT is payable on the reduction in the value of a person’s estate as a result of a transfer.
1.2 What is a taxable estate?
A person’s estate is the aggregate of all the property to which he is beneficially entitled.
So, you’ll need to include:
- All assets (this is worldwide assets so don’t forget any that are overseas)
This includes land and property, investments (including ISAs – see below), money, cars, jewellery, and share of any jointly owned assets.
It also includes any gifts made in the previous 7 years.
- Any debts and liabilities (including mortgages and credit card debt)
Are ISAs exempt from Inheritance Tax?
The tax-free benefits of ISAs apply only to Income Tax and Capital Gains Tax.
They do not apply to Inheritance Tax and so any ISAs held by an individual at the time of their death will become part of their taxable estate.
1.3 What is the rate of Inheritance Tax?
The main rate of IHT is 40%.
The lifetime rate is half of the main rate (ie 20%).
Note that before the main rate kicks in there is a Nil Rate Band (“NRB”) of £325,000.
So, if your taxable estate was £525,000 then the first £325,000 is taxed at 0% and the next £200,000 is taxed at 40%, giving an IHT liability of £80,000.
2. How to avoid Inheritance Tax
2.1 Accept that you are not immortal!
As a tax manager with over 30 years of experience in dealing with IHT, I can tell you that one of the main issues with avoiding it is …
In this world nothing can be said to be certain, except death and taxes.Benjamin Franklin
IHT combines these certainties as it’s a tax that is paid on death.
Giving consideration to IHT forces us to consider our own mortality.
And we don’t like doing that, do we?
It’s as if contemplating our eventual demise will somehow make it happen sooner!
So, the first step in avoiding IHT is … accepting that you are not immortal!
2.2 IHT is a voluntary tax
Inheritance Tax; – it is, broadly speaking, a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue.Roy Jenkins
What? IHT is voluntary? What is he on about?
IHT is often described as a voluntary tax because you can, with planning, avoid it (or at least greatly mitigate its impact).
2.3 Avoiding IHT
2.3.1 Is it legal to avoid IHT?
First things first, a little clarification on what we are undertaking.
Evasion of tax is using illegal means so as not to pay the due tax.
Avoidance of tax is using legal means to reduce or eliminate liability.
Everything that is being discussed here is with the objective of avoiding IHT.
To emphasise the fact, here is a quote that I always remember from my tax studies:
No man in this country is under the smallest obligation, moral or other, so to arrange his legal relations to his business or to his property as to enable the Inland Revenue to put the largest possible shovel into his stores.Lord Clyde
There are some that would argue that the advent of the General Anti-Abuse Rule (GAAR) legislation means that ‘tax avoidance is dead’.
However, GAAR is designed to tackle those who seek to exploit legal loopholes (think of the schemes like those used by comedian Jimmy Carr – perfectly legal, and fully disclosed to HM Revenue & Customs, but not within the spirit of the law).
We are not doing that. We are simply making the best use of reliefs and exemptions that everyday people may not be aware of.
2.3.2 Reduce it or provide for it
So, in order to avoid leaving your loved ones with an IHT liability you have 2 options:
- Take out a life insurance policy to cover the estimated IHT liability
- Reduce the estimated liability through planning measures
Whether or not option 1 appeals to you may well depend upon your age. Generally speaking, the older you get the more expensive the life insurance policy premiums become.
If you do take out a policy you should ensure that it is one that pays into trust rather than to your estate (you don’t want to make the IHT situation worse!).
2.3.3 Reliefs and exemptions – Spousal transfers
Any value that is transferred to your spouse is exempt from IHT.
Although this has some value it is really just ‘kicking the can down the road’ as the spouse will have a larger estate on their death when considering IHT.
2.3.4 Reliefs and exemptions – Residential NRB
We saw above that there is a 0% band of IHT, the NRB, of £325,000.
There is also a Residential NRB, extending the 0% band by a further £175,000 and thereby giving each individual a total of £500,000.
Any unused proportion of these NRBs may be transferred to a spouse on death – thus providing £1,000,000 at 0% for a married couple.
In order to qualify for the Residential NRB the individual must, on death, pass a qualifying residence to their direct descendants.
Note that once the value of an individual’s estate exceeds £2,000,000 the amount of the Residential NRB is tapered away at the rate of £1 for every £2 that the estate value exceeds the limit.
One of the ways in which the IHT collected by HM Revenue & Customs has increased is the fact that the NRB has not been increased since 2010.
2.3.5 Reliefs and exemptions – Business Property Relief
Business Property Relief (“BPR”) provides 100% relief in respect of the value of any assets, including shares in an unlisted trading company, which are used for business purposes.
Now, you may be thinking ‘That’s no use for me, I don’t own any business assets!‘.
Maybe so, but you could …
It is fairly easy to buy shares in trading companies that are listed on the Alternative Investment Market (“AIM”). This is part of the London Stock Exchange but the shares are in smaller, more risky companies than those on the main exchange.
Once you have owned the shares for the qualifying 2-year period they attract 100% BPR and so no longer form part of your IHT estate.
So, if you replace £100,000 of cash that would be subject to IHT with £100,000 in AIM shares then, after 2 years, you will have saved yourself £40,000.
As the companies on AIM are riskier compared to those on the main exchange you must weigh the investment risk against the potential of a 40% IHT saving on the funds invested.
If you are contemplating an AIM-based investment then it would be prudent to discuss it with your financial adviser.
2.3.6 Reliefs and exemptions – Agricultural Property Relief
Agricultural Property Relief (“APR”) is similar to BPR but applies to the value of assets used for the purposes of agriculture.
For example, land that is actively farmed by the owner.
This is useful if you happen to own such assets but isn’t something that is easily accessible if you don’t.
2.3.7 Reliefs and exemptions – Gifts
There are 2 types of gifts for IHT purposes:
- Automatically exempt
- Potentially exempt
Automatically Exempt Gifts
Automatically exempt gifts, as the name suggests, will immediately leave your taxable estate for IHT purposes.
There are a number of statutory provisions for gifts that are automatically exempt. These are:
- Annual Allowance
This has a limit of £3,000 per person. It may not sound like much but if you use the full allowance each year for 10 years then you will have saved £12,000 in IHT. That is, your gifts of £30,000 only cost you £18,000!
- Small Gifts Allowance
You can give away up to £250 to as many people as you like (excluding recipients of a full annual allowance gift).
- Wedding Gifts
You can make wedding gifts of £5,000 to your children, £2,500 to grandchildren (or great-grandchildren), and £1,000 to any friend or relative.
- Gifts Out of Surplus Income
This one is hugely valuable. If you have surplus income after meeting all of your usual living costs then you can give away the excess (rather than have it add further to your taxable estate). There is no limit on this allowance but the payments must be regular.
Potentially Exempt Gifts
Potentially exempt gifts, or Potentially Exempt Transfers (“PET”s) as they are referred to in the legislation, only leave your estate once a period of 7 years has elapsed after the date of the gift.
So, if you give away £100,000 to one of your children and survive for a further 7 years then that amount leaves your IHT estate and you have saved £40,000 in IHT.
Should you not survive the gift by 7 years then there is a tapering scale of IHT applied to the amount of the PET. This scale is as follows:
|Years between gift and death||Rate of IHT|
|0 to 3 years||40%|
|3 to 4 years||32%|
|4 to 5 years||24%|
|5 to 6 years||16%|
|6 to 7 years||8%|
|7 or more years||0%|
Note that the tapered IHT rate only applies where total gifts have exceeded the NRB.
If you give something away but continue to benefit from it just as you did before the gift then this is known as a Gift With Reservation of Benefit (“GWRB”).
GWRBs continue to form part of your IHT taxable estate.
So, if, for example, you give your home away but continue to live there then it will still form part of your estate.
TIP: If you give away your home AND pay a market rent to the recipient of the gift then this becomes a genuine PET and not a GWRB. That is, it does leave your estate for tax purposes after 7 years.
2.4 Paying IHT – Who, When, and How
Who pays IHT?
IHT is normally paid by the executors of a deceased individual’s estate.
The only exception to this is if you give away more than the NRB in the 7 years prior to your death. The recipients of gifts after the NRB is exceeded will have to pay the IHT on the gift.
For example, if Leonard gives £325,000 to Penny 5 years before his death and £100,000 to Sheldon 3 years before his death, there will be no IHT payable by Penny as the gift is within the NRB. Sheldon, however, will have to pay IHT at 32% on his £100,000.
When is IHT due?
IHT is due by the end of the 6th month after the individual died.
So, if Leonard died in April 2022 any IHT liability is payable by 31 October 2022.
Interest is charged on late payments.
How is IHT paid?
Payment of IHT requires a payment reference number from HM Revenue & Customs.
You can pay:
- Using telephone banking
- At your bank or building society
- By cheque in the post (*)
* HM Revenue & Customs are gradually moving away from accepting cheque payments. At the time of writing it is still possible to use cheques but you should check that this is still the case if you choose to use this method of payment.
3. Inheritance Tax and Pensions
As we saw above, IHT is paid on a person’s taxable estate.
The majority of defined contribution pension plans do not fall within an individual’s IHT taxable estate and, therefore, IHT is not payable on the funds within these plans.
It would be prudent to seek confirmation of this point from your plan provider.
If you have a plan that does not fall outside of your IHT taxable estate then you may wish to transfer it to another plan that does fall outside. Just make sure that you aren’t going to lose any valuable benefits by doing so – if in doubt, speak with a financial adviser.
The fact that pension plans escape IHT does provide some scope for financial planning in retirement.
For example, if you draw on your pension in preference to other sources then these retained other sources may suffer IHT on your death. Whereas, if you draw from these other sources first, you can pass on your pension funds IHT-free.
Potentially, therefore, pensions can be a very attractive way of avoiding IHT and passing on funds to the next generation.
Passing on your pension:
- Note that the transfer of your pension funds on death is not governed by your will
- Rather, it is determined by an Expression of Wish nomination submitted to the trustees of each of your pension funds
4. IHT and Charitable Donations
Remember when I said that the main rate of IHT was 40%?
Well, what if I told you that you could reduce that rate to 36% by leaving charitable donations in your will?
Would you be interested? Of course, you would!
Making charitable donations offers a double whammy for IHT planning:
- Donations reduce the value of your taxable IHT estate
- If you leave 10% (or more) of your net estate to charities your IHT rate becomes 36%
Example of the impact of donations
Let’s say that Leonard has an estate of £800,000 and he leaves £25,000 to his favourite charity, the Dogs Trust.
Can his IHT rate be reduced?
|Nil Rate band||(325,000)|
|Add back charitable donation||25,000|
|10% of net estate||47,500|
Leonard’s donation of £25,000 is less than 10% of the net estate (£47,500) and so IHT at 40% is payable on the taxable estate (£450,000 x 40% = £180,000).
Let’s revisit the situation but this time increase the donation to £50,000.
|Nil Rate band||(325,000)|
|Add back charitable donation||50,000|
|10% of net estate||47,500|
Leonard’s donation of £50,000 is now more than 10% of the net estate (£47,500) and so IHT at 36% is payable on the taxable estate (£425,000 x 36% = £153,000).
So, paying an additional £25,000 to the Dog’s Trust has resulted in the IHT liability being reduced by £27,000 (£180,000 – £153,000).
Just to drive the point home, let’s compare how Leonard’s estate is distributed in each scenario:
|Narrative||40% IHT||36% IHT|
|IHT to HM Revenue & Customs||(180,000)||(153,000)|
|Residual estate to beneficiaries||595,000||597,000|
Making a charitable donation equal to more than 10% of your net estate can result in more funds for your chosen charity AND more funds for your chosen beneficiaries!
As you can see, if you are making charitable donations anyway – you may wish to look at whether making more may be beneficial.
How do you calculate Inheritance Tax?
- Calculate the value of your estate (basically, everything that you own)
- Deduct any reliefs (eg Business Property Relief)
- Deduct any charitable donations
- Deduct the Nil Rate Band (currently £325,000)
- Deduct the Residential Nil Rate Band if applicable
- Apply the applicable rate of tax (normally 40% but could be 36% if sufficient charitable donations are made)
How do I avoid Inheritance Tax on my parent's house?
First of all, despite what the bloke down the pub may say, it is not as simple as transferring ownership from your parents to you. That would be regarded as a Gift With Reservation of Benefit (“GWRB”), making the transfer ineffective for Inheritance Tax purposes.
What you must do, in addition to transferring the ownership of the house, is to draw up an agreement for your parents to pay you, as the owner of the property, a full market rent – this avoids the GWRB issue.
Two other things to keep in mind:
1. Depending on the values involved, the combination of the Nil Rate Band and Residential Nil Rate Band may mean that there is no Inheritance Tax liability. Do your calculations before going to the effort and expense of a property transfer and rent agreement.
2. The value of the house will not leave your parent’s estate immediately. It will be a Potentially Exempt Transfer, meaning that your parents must survive longer than 7 years after making the gift for it to be fully effective (tapered rates of Inheritance Tax apply if they do not).
How do charitable donations reduce Inheritance Tax?
Charitable donations can potentially reduce Inheritance tax in 2 ways.
Firstly, charitable donations are deducted when calculating a person’s chargeable estate for Inheritance Tax purposes.
Secondly, if the level of donations exceeds 10% of a person’s net estate then the applicable rate of tax is reduced from 40% to 36%. This may not sound like much of a reduction but it can result in a scenario where both the charities and ultimate beneficiaries of the estate are better off (at the expense of HM Revenue & Customs!).
Do my beneficiaries have to pay Inheritance Tax on my pension funds?
You should always request confirmation from your pension provider(s), but the vast majority of pension funds fall outside your taxable estate for Inheritance Tax purposes. Therefore, your executors will not have to pay Inheritance Tax on the funds and your beneficiaries may receive the pension funds without a deduction (*).
* Note, however, that if you are over 75 when you die then Income Tax may be payable when your beneficiaries draw on your pension funds.
The Government’s house price index shows that the average house price in England now stands at a staggering £299,429.
When the IHT NRB has not seen such growth (or, indeed, any growth for many years) and is still at £325,000 you can see how quickly IHT can begin to bite for those of us that would not consider ourselves to be ‘rich’.
Once you add in a car, jewellery, savings accounts, etc it isn’t long before IHT applies.
I hope that you have found this retiree’s guide to Inheritance Tax to be useful.
However, to make it truly valuable rather than simply useful, I would urge you to keep in mind the following:
Key points from the Retiree’s Guide to Inheritance Tax:
* Accept that you are not immortal!
* Calculate your potential exposure to IHT
* Remember IHT is voluntary: If there is a liability – plan how to avoid it!