The main way to reduce the amount of inheritance tax paid on an estate is to use the nil-rate band. The nil-rate band is the first £325,000 of an individual’s estate where no inheritance tax is paid.
The residence nil-rate Band (RNRB) was introduced in April 2017 and is an extra allowance on top of the standard nil-rate band.
The RNRB applies if the:
- Individual dies on or after 6 April 2017;
- Individual owns a home*, or a share of one, so it’s included in their estate;
- Individual’s direct descendants such as children or grandchildren inherit the home, or a share of it
*the RNRB may also apply where an individual downsized to a lower value property, sold their home, or gave away their home on or after 8 July 2015.
Tapering of the RNRB will apply where the net value of the estate (after deducting liabilities but before reliefs and exemptions) is more than £2 million. £1 of RNRB is lost for every £2 in excess of £2 million.
For deaths in the following tax years the RNRB will be:
- £100,000 in 2017/18
- £125,000 in 2018/19
- £150,000 in 2019/20
- £175,000 in 2020/2021
This means that couples who qualify for RNRB will be entitled to a combined nil-rate band of £850,000 (£425,000 each) in 2018/19 rising to £1 million (£500,000 each) in 2020/21.
Above the nil-rate band, inheritance tax is payable on our estate at a rate of 40% (although this can reduce to 36% on some assets where 10% or more of the net estate is left to charity).
The main method of reducing the value of your estate below or nearer to your nil-rate band is to make lifetime gifts. Some of these are immediately outside of our estate, or ‘exempt’, some are potentially exempt and some give rise to an immediate tax charge (chargeable lifetime transfers).
Exempt gifts or ‘transfers’
Everyone gets annual inheritance tax allowances, which allow us to make gifts that fall immediately outside our estates. For example, everyone is allowed to make annual gifts of up to £3,000 to anyone. This allowance can be carried forward up to one year, doubling it up to £6,000 if no gifts were made in the previous tax year.
Other allowances cover gifts to those getting married or entering into a civil partnership, small gifts to any number of people and gifts out of normal expenditure.
Gifts made to spouses or civil partners are also exempt.
Potentially exempt transfers
Gifts that don’t fall within the annual allowances may still avoid inheritance tax if the person making the gift (the donor) lives for seven years after the gift is made. These are known as ‘potentially exempt transfers’, or PETs for short. There is no tax payable at the point a PET is made, no matter how large the gift.
Outright gifts to individuals and those made into a ‘bare’ or ‘absolute’ trust are the two main types of gift that would usually be treated as PETs.
Taper relief reduces the tax liability where the PET was made more than three years prior to the donor’s death. But taper relief does not reduce the value of the PET itself, meaning that its full value is still part of your estate if you die within seven years of the date the gift is made.
Rather than reducing the value of the gift, taper relief reduces the amount of tax due according to the length of time between the donor’s death and the date the PET was made, as set out in the following table:
|Number of years before death of donor the PETs PET made||
Percentage of full amount of IHT payable
|0 – 3 years
|3 – 4 years||80%|
|4 – 5 years||60%|
|5 – 6 years||40%|
|6 – 7 years||20%|
|Over 7 years||0%|
Please note that if the gift falls within the available nil-rate band (£325,000) there is no tax due, and hence no tapering.
For example, Mr Smith gifts £100,000 to his son and dies five and a half years later. He’s made no other gifts. The gift is a PET, but there is no tax due because it uses the first £100,000 of his available nil-rate band, and there is no tapering. If the gift had been £400,000, this means that £75,000 is taxable (£400,000 - £325,000). The tax due is £75,000 x 40% IHT = £30,000, x 40% tapering = £12,000.
Chargeable lifetime transfers
A gift may be chargeable to IHT immediately. This is called a chargeable lifetime transfer and applies to transfers that are not exempt or potentially exempt. For example, a gift made to a discretionary trust is treated as a chargeable lifetime transfer.
The value of a chargeable lifetime transfer is added to other chargeable lifetime transfers made within the last seven years. If the combined amount exceeds the nil-rate band, then tax is payable immediately on the excess at a rate of 20%. Further inheritance tax may be payable if the donor dies within seven years of making a chargeable lifetime transfer.