Understanding Inheritance Tax: Key Thresholds, Rules and Allowances Explained

Inheritance Tax can be a complex topic, but understanding how it works is essential for effective estate planning. This tax applies to the property, money, and possessions left behind when someone dies. Knowing the key thresholds, rules, and allowances can help you plan ahead and potentially reduce the tax burden on your loved ones.

What Is Inheritance Tax?

Inheritance Tax is charged on the estate of a person who has passed away. The estate includes everything they owned: property, savings, investments, and personal belongings. The tax only applies if the estate’s value exceeds a certain threshold.

There is usually no Inheritance Tax to pay if:

• The estate’s value is below £325,000

  
  

• Everything above £325,000 is left to a spouse, civil partner, charity, or community amateur sports club

  
  

Even if the estate is below the threshold, it may still need to be reported to HM Revenue & Customs (HMRC).

How Thresholds Work

The standard tax-free threshold is £325,000. This means that if the total value of the estate is less than this amount, no Inheritance Tax is due.

If you leave your home to your children or grandchildren (including adopted, foster, or stepchildren), the threshold can increase to £500,000. This is known as the residence nil-rate band.

For married couples or civil partners, any unused threshold can be transferred to the surviving partner. This means that when the second partner dies, their estate could benefit from a combined threshold of up to £1 million (or £1 million plus the residence nil-rate band if applicable).

Passing on a Home

Leaving your home to direct descendants can increase the tax-free allowance. This allowance is designed to help families keep the family home without facing a large tax bill.

Here are some important points about passing on a home:

• The home must be left to children or grandchildren to qualify for the increased threshold.

  
  

• The residence nil-rate band starts at £175,000 and can increase each tax year.

  
  

• If the home is sold before death, or left to someone other than direct descendants, the increased threshold does not apply.

  
  

For example, if your estate includes a home worth £300,000 and you leave it to your children, your total threshold could be £500,000. If the estate is worth £600,000, only £100,000 would be subject to Inheritance Tax.

Rules on Giving Gifts

Gifts made during your lifetime can affect Inheritance Tax. If you give away money or assets and then die within seven years, these gifts may be added back into your estate for tax purposes.

Key points about gifts:

• Gifts made more than seven years before death are usually exempt from Inheritance Tax.

  
  

• Gifts made within seven years may be taxed, but taper relief can reduce the tax if death occurs more than three years after the gift.

  
  

• Some gifts, such as those to spouses or charities, are exempt from tax regardless of timing.

  
  

For example, if you gave £50,000 to a friend five years before you died, this amount might be added to your estate’s value for Inheritance Tax calculations. However, taper relief could reduce the tax payable on this gift.

If You Die When You Are Based Outside the UK

Inheritance Tax rules can differ if you are not domiciled in the UK. Your domicile status affects which assets are subject to UK Inheritance Tax.

• If you are domiciled in the UK, your worldwide assets are subject to Inheritance Tax.

  
  

• If you are not domiciled in the UK, only your UK assets are subject to the tax.

  
  

It is important to understand your domicile status and how it affects your estate planning, especially if you have assets in multiple countries.

Inheritance Tax Rates

The standard Inheritance Tax rate is 40%. This rate applies only to the part of the estate that exceeds the tax-free threshold.

For example, if your estate is worth £500,000 and your threshold is £325,000, the tax is charged on £175,000. At 40%, this means £70,000 of Inheritance Tax is due.

There is a reduced rate of 36% if you leave at least 10% of the net estate value to charity. The net value is the estate’s total value minus any debts.

Reliefs and Exemptions

Certain reliefs can reduce the amount of Inheritance Tax payable:

• Business Relief allows some business assets to be passed on free of tax or with a reduced rate.

  
  

• Agricultural Relief may apply if your estate includes farmland or woodland. Contact the Inheritance Tax helpline for details.

  
  

These reliefs can significantly reduce the tax burden but require careful planning and understanding of eligibility.

Who Pays the Tax?

Inheritance Tax is paid from the estate before assets are distributed to beneficiaries. Executors or administrators of the estate are responsible for ensuring the tax is paid to HMRC.

This means the estate’s value is reduced by the tax amount before heirs receive their inheritance.

Understanding Inheritance Tax thresholds, rules, and allowances helps you plan your estate wisely. By knowing how the tax works, you can take steps to protect your assets and reduce the tax burden on your loved ones. Consider seeking professional advice to explore reliefs and exemptions that may apply to your situation.

For expert assistance with tax matters, including strategic inheritance tax planning, consider reaching out to the specialists at S K Punia Accountants LLP