Dealing with important financial affairs following the death of a loved one can be an awfully stressful period. One such factor that you need to be made aware of is with respect to inheritance tax. In fact, inheritance tax could see you liable for hundreds of thousands of pound if the necessary steps are not undertaken.
However, it is also important to note that in some cases you might be in a position to reduce what you owe, or potentially, not pay anything at all.
As such, by reading our complete guide on How to Avoid Inheritance Tax in the UK, we’ll show you everything you need to know.
This will include an overview on what inheritance tax actually is, why you might need to pay, how much you’ll likely need to pay and perhaps most importantly, what you can do to reduce your liability.
Let’s start by getting a firm understanding of what UK inheritance tax is.
What is Inheritance tax?
In its most basic form, inheritance tax is the amount of tax you need to pay the government on assets left to you when somebody passes away. While the origins of inheritance tax dates all the way back to the 17th century, modern inheritance tax as we know it today was first introduced in 1894.
Although we will discuss this in a lot more detail further down, there are two key factors that will determine if you can avoid paying inheritance tax in the UK.
As advised by HMRC, if the value of your estate is under £325,000, then there is normally no inheritance tax to pay.
Alternatively, if you leave anything above the £325,000 threshold to a civil partner, spouse, community amertur sports club or a charity, then tax is usually not liable.
Furthermore, the UK inheritance threshold increases to £475,000 if you subsequently leave your property to your children or grandchildren.
In the UK, inheritance tax rates are extremely high, amounting to 40% of everything over the aforementioned thresholds. For example, if your estate is worth £450,000, and you take into account the £325,000 threshold, then £125,000 in inheritance tax would be due. As such, 40% of £125,000 would amount to an inheritance tax liability of £50,000.
Alternatively, and once again this will be expanded upon further down, if your estate was worth £700,000 and you left your property to your children, then you would pay inheritance tax on everything over £475,000. In this example, you’d pay 40% tax on the £225,000 difference, which would equate to £90,000 in inheritance tax obligations.
However, although the above figures have been utilized to give you an idea of what the general rules dictate, there are many other factors that will determine how much inheritance tax you pay, if at all.
So now that you have a better idea as to what inheritance tax actually is, in the next section of our guide we are going to explore how the UK government determines how much your estate is worth.
UK Inheritance tax: How Much is my Estate Worth?
In the previous section we made reference to the standard inheritance tax thresholds, which were based on the value of your estate. In layman terms, your estate is essentially how much the overall assets are worth at the time of the death.
This can be an awfully complex process, and thus, while we will give you a comprehensive overview of the key factors you need to consider, you should always seek the advice of a qualified legal practitioner.
First and foremost, you need to assess the value of the any assets held at the time of the death. Assets are classed as anything that has an intrinsic value, such as the below.
- Cash held in a bank account
- Investments such as stocks and shares, bonds or mutual funds
- Properties that are owned or partly owned
- Business interests
- Any proceeds from a life insurance policy
Some of the asset classes listed above, such as investment or business interests, can be hard to value, which is why you are likely to need assistance from a qualified professional.
Nevertheless, the next stage in ascertaining the total value of the estate is to value each and every gift that was made in the seven years prior to death. Although this might sound somewhat complex, HMRC will expect you to make every effort possible when totaling the value of each gift up.
For those unaware, a gift is classed as anything with value, and often includes property and money. However, to make things even more complicated, certain gifts are exempt from the inheritance tax estate calculation.
Firstly, you are allowed up to £3,000 worth of gifts in every tax year, which runs from April 6th to April 5th. HMRC call this your annual exemption.
Furthermore, christmas and birthday presents upto £250 are exempted gifts, as are wedding or civil ceremony gifts of up to £5,000 for a child, £2,500 for a grandchild or £1,000 for anyone else. Moreover, gifts in the form of charity are also exempt.
Once you have calculated the total amount of assets held at the time of death, as well as the total amount of gifts received in the seven years prior to death, you need to add the two figures together.
Before ascertaining how much inheritance tax you will be liable to pay, if at all, you first need to incorporate any debts or liabilities in to the calculation. In most cases this will include mortgages, outstanding bills or invoices and funeral costs.
Finally, once you subtract the aforementioned liabilities from your total assets and gifts, you’ll be left with the net value of your estate.
So now that you have an idea as to how the value of your estate is calculated, in the next section of our guide we’ll look at the ‘Main Residence’ allowance.
What is the Main Residence Allowance?
First and foremost, it is important to note that the rules surrounding inheritance tax are ultra-political. As such, the rules often change when there is a change of political power.
The reason for this is that inheritance tax is one of the most controversial tax bands in existence. On the one hand, the underlying justification behind inheritance tax is to ensure that wealth is redistributed. In other words, if the wealthy are not attributable to tax when they die, their children will simply stay wealthy without paying their fair share.
The argument from the other side of the political fence is that those attributable to inheritance tax would have already paid their dues while they were alive.
There is also an issue with the tax thresholds set in the UK because of rising property prices. This is especially true in London where property prices have outpaced the rest of the country for some time now. While London-based homeowners might have a significant amount of value in their property, this is often reflected in the cost of living.
Nevertheless the reason that we mention this is that a new rule was introduced in the 2017/18 tax year that could affect how much inheritance tax you need to pay.
Known as the ‘Main Residence’ allowance, the rule change states that certain allowances can be made if a child, step-child or grandchild of the deceased has a property passed down to them, and the beenfically is using that property as their main residence.
Each tax year, the main allowance threshold increases. In the 2019/20 tax year, the allowance allocates an additional £150,000 on top of the current threshold. As such, on top of the £325,000 single estate threshold (or £650,000 if married), you can receive an extra £150,000 before you are liable for inheritance tax.
Let’s look at a quick example so you have a full understanding of why the main residence threshold is crucial.
- Let’s say that you receive a total estate of £750,000, with no debts or gifts.
- You’re single, so you already have a threshold of £325,000 before you pay any inheritance tax.
- However, as you also get an allowance of £150,000 from the main residence scheme, you won’t pay any tax on the first £475,000.
- As such, taking into account your £750,000 estate, less the allowance of £475,000, you’ll need to pay inheritance tax on £275,000.
- Thus, at a tax rate of 40%, you’ll need to pay HMRC £110,000.
It is also importance to make reference to those that are in receipt of an estate worth more than £2 million. For everything upto the first £2 million, you’ll be eligible for all of the aforementioned tax allowances.
However, for everything over the £2 million mark, homeowners will lose £1 for every £2 in allowance. For example, if you are single and the property is worth £2,175,000, then you’ll receive no additional allowance.
Take note, in the 2020/21 tax year, the main residence allowance will increase by a further £25,000, taking the total to £175,000.
So now that we’ve covered the ins and outs of the main residence allowance, in the next section of our guide we are going to take a closer look at what exemptions are available if you are married.
Do I Still Need to pay Inheritance tax if I am Married?
UK tax laws often make certain concessions when it comes to married couples, and this is no different in the case of inheritance tax. In a nutshell, if you leave your estate to your spouse or registered civil partner, the beneficiary is subsequently exempt from paying any inheritance tax on the assets.
Not only this, but because you did not utilize any of your allowance, this is subsequently passed on to the beneficiary and thus, increases their own allowance upon death.
Once again this might sound somewhat complex, so let’s take a look at a quick example to ensure you have a full understanding.
- Let’s say that you and your spouse have a total of £1 million in combined assets.
- When you pass away and subsequently pass on the assets to your spouse, you would have otherwise had an inheritance tax allowance of £325,000, plus the £150,000 from the main residence allowance.
- As such, not only would your spouse have an allowance of £475,000 themselves, but she would also get your allowance of £475,000.
- This total of £950,000 in allowance means that when your spouse dies, the £1 million in assets would only attract a total of £50,000 in inheritance tax.
Does the Married Inheritance tax Allowance Take into Account the Time of Death?
To continue on from the above discussion on passing on your tax allowance to your spouse, it is also important to note that timing also plays a part when calculating how much of your allowance you can pass on.
In a nutshell, the amount of allowance that be passed on is based on the proportion of the allowance utilized at the time of death, if at all. Let’s take a look at an example.
- Let’s say that your spouse died 10 years ago when the per-person inheritance tax allowance was £200,000.
- At the time, your spouse left £25,000 to each of his four children – meaning that £100,000 of his allowance was used, or 50%.
- Everything else was passed on to you and thus, you benefited from the married couple allowance.
- However, when you pass away, on top of the £450,000 allowance you currently have, you can also use the remaining 50% that your spouse did not use.
- The remaining 50% would be calculated against the current tax allowance of £475,000 (or whatever it is at the time of death), which would be £237,500.
- Ultimately, this means that you would be afforded a total inheritance tax allowance of £712,500.
So now that you have a good understanding of the allowances made to married couples, in the next section we are going to look at some of the potential ways you can reduce what you pay in inheritance tax.
How can I Reduce the Amount of Inheritance tax I pay?
If you’ve read our guide up to this point, then you might remember how we discussed the importance of gifts when calculating the total value of the estate. The reason this is important is that unless the gift is exempt (see exemptions in earlier section: UK Inheritance tax: How Much is my Estate Worth?), each and every gift made in the seven years prior to death must be accounted for.
However, although might sound like an unfair stipulation, the gift rule is actually one of the easiest ways to reduce your inheritance tax liability. We’ll discuss some of the most common methods that you can utilize below.
The 7 Year Rule
While this particular method might sound rather unconventional, it could actually reduce the amount of inheritance tax liable by a considerable amount. Essentially, any gifts that were made more than 7 years from the date of your death are not liable for inheritance tax.
For example, if you gave a significant proportion of your assets away to your children, and you subsequently lived-on for at least another 7 years, then your children would pay no tax on the gift.
A further point to note is that the beneficiary of your gifts could also take-out a life insurance policy to protect them in the event that you pass away before the 7 year rule comes into place. However, this would only be worthwhile if the value of the gifts were of significant size.
Finally, although it has been known that placing gifts into a trust is a sure-fire way of avoiding inheritance tax, this is not strictly true. On the contrary, most trusts are now liable for inheritance tax. However, this is a very specialist area of the law and thus, it might be worth seeking professional guidance.
Reduced Inheritance tax Rate for Gifts
While all gifts are exempt from inheritance tax if they were giving away at least 7 years or more from the time of death, if you don’t quite make the 7 years there are other reductions possible.
As you’ll see from the chart below, you can reduce your gift tax rate from 40% as long as long as there was a period of 3 years or more between the death, and the date the gift was given.
For example, if you gave a £50,000 gift 6 years before you died, on top of the £3,000 annual gift discussed below, you’d only pay an inheritance tax rate of 8% on that specific gift.
|Years between gift and death
|less than 3
|3 to 4
|4 to 5
|5 to 6
|6 to 7
|7 or more
Yearly Gifts of £3,000
Another option that you have available to you in your quest to avoid inheritance tax for your beneficiaries is to engage in annual gift payments of £3,000. Essentially, everyone is entitled to a £3,000 ‘gift allowance’, meaning that if done for a prolonged period of time, it could make up a substantial part of the amount of assets you intend on passing over.
It is importance to note that although the £3,000 gift allowance allocation can be carried forward in to a future tax year, this can only be utilized once.
Give to charity
Not only will leaving some of your estate to charity allow you enjoy the fruits of philanthropy, but you’ll also have the opportunity to reduce your inheritance tax rate. While the standard inheritance tax rate amounts to 40%, you can actually reduce this to 36% if you leave at least 10% of your net assets to charity.
To further understand how this works, take a look at the following example.
- Your total estate is worth £600,000, and you have a total allowance of £325,000, plus £150,000 from the main residence allowance – giving you a total allowance of £475,000.
- As such, the difference between £600,000 and £475,00 is £125,000, which is the total amount of net assets liable for inheritance tax.
- Ordinarily, at a tax rate of 40%, you would pay a total of £50,000.
- However, if you wanted to utilize the charity exemption, you would need to give 10% of your net assets away, which would be £12,500 (10% of £125,000).
- As such, that would leave you with £112,500 in net assets at an inheritance tax rate of 36%, meaning you’d pay £40,500.
Just remember, although in this example you are paying less in inheritance tax, the amount of money your beneficial gets is actually less. However, if giving money away to charity was something you had planned to do anyway, then it’s well worth looking into the tax exemptions available.
£250 Annual Gift Allowance Per-Person
On top of the £3,000 annual gift allowance we discussed above, you can also utilize the £250 gift allocation too. In a nutshell, you are able to give upto £250 as a gift to as many people you want, every year.
For example, if you had 5 children and 10 grandchildren, you could effectively give 15 lots of £250 away, subsequently allowing you to chip away at your liability by an extra £3,750 per year.
How to Avoid Inheritance Tax in the UK: The Verdict?
In summary, if you’ve read our guide from start to finish, you’ll no doubt have a good understanding of just how complex inheritance tax is. There are so many derivatives that constitute not only how much your assets are worth, but also the value of any gifts.
Moreover, you also need to take into account key factors such as whether you are married, and whether or not your beneficiary can benefit from the main resident allowance.
With all that being said, while we hope that you now have a much better grasp of how you can avoid, or at the very least reduce, the amount of inheritance tax your liable to pay, it is highly recommended to seek the advice of a professional.
They’ll be able to undergo a full analysis of the value of the estate, alongside what tax you’ll likely need to pay. Furthermore, they’ll also be able to advise you on any notable steps you can take to reduce your inheritance tax liabilities, or avoid it in its entirety.