Understanding inheritance tax

Is there a way to leave money to our loved ones without falling foul of the law?

By Helen Booth

Let’s be honest, nobody likes talking about money, least of all when we lose someone close. Take inheritance tax – it’s something many of us worry about but don’t deal with until circumstance forces us to. It can make an already difficult time even worse.

Peter, a professional landlord, agrees. “I think this is a real elephant in the room subject,” he says. “Inheritance tax problems come to people at the end of their lives when they’re not in the best state to cope with them. We don’t realise just how hard it is until it happens.”

The tax is a charge on the estate – the money, property and possessions – of someone who dies. With the current threshold at £325,000, anything above that may be taxed at 40%. Tax rules are subject to change and depend on individual circumstances, but considering house prices in parts of the country, it’s no wonder the mere mention of it instils dread in so many.

Is our fear justified?

In the UK, only around 125,000 estates a year are liable for inheritance tax. That means less than 5% of estates are affected, given 570,000 people die here each year. Yet around half of the families fill in the forms, and that can be a challenging process.

"I had to deal with my mother’s estate when she died a couple of years ago,” continues Peter. “There was a small amount of inheritance tax to pay but, quite honestly, the forms were horrendous.”

Last year, more than 3,500 people responded to the Office of Tax Simplification’s review of inheritance tax . Many said the system was far too complex and difficult.

So, are there steps you can take to make it easier for your nearest and dearest when your time comes? The answer is yes, provided you plan for the inevitable.

Making the tax less taxing

Emily Deane is Technical Counsel at STEP, the worldwide professional organisation for family inheritance and succession planning specialists. She shares her tips for easing the burden:

1. Make a will

It may sound obvious, but it’s surprising how many people don’t have one. A will means you can decide who gets your assets when you die, giving you greater control over how much tax your estate has to pay. Make sure you review it regularly – your circumstances could change.

You should also consider making a lasting power of attorney with a person you trust. This legal document lets you appoint someone to help you make decisions, or to make them on your behalf, should it be necessary

2. Know your relationship status

People often assume that partners who live together long term automatically get the same rights as a married couple. But Emily says that’s a myth. “‘Common-law marriage’ is not recognised by the law of England and Wales or Northern Ireland. You need to be married or in a civil partnership to rely on the law for dividing finances if you split up, or if one of you dies.”

And she warns: “If your partner dies, you have no rights to his or her money and property unless a will was made, stipulating who should receive what.”

If you’re married or in a civil partnership, you can pass everything to your spouse or civil partner, tax-free, on death. This includes your home. When they die, they'll be able to leave up to £650,000 tax-free, which is double the nil-rate band threshold.

Both of you get an additional £175,000 tax-free to use against the value of your home, but only if you leave it to your children or grandchildren. This means for the financial year 2021/22, couples can pass on up to £1 Million tax-free. For others, the figure is £500,000.

The 2021/22 residence nil rate band is £175,000. This allowance can be transferred to your spouse or civil partner if it hasn’t been used up, which means you can leave your family a combined estate of up to £1 million tax-free. If you’re not married, but live with your partner, he or she cannot benefit from these tax advantages.

Only after you deduct all inheritance exemptions will the 40% rate come into effect. And you can cut this to 36% if you leave at least 10% of your estate to charity.

3. Master the art of giving

Gifting is another way to reduce your estate’s liability. You can give up to £3,000 every year tax-free and gifts of £250 to as many people as you like. All charitable donations are tax-free too. You can also give wedding gifts of up to £5,000 to your children, £2,500 to grandchildren and £1,000 to anyone else.

You can give away more, but you’ll have to live for seven years for it to be tax-free. If you live for less, the gift remains in the estate so uses up some – or all – of the nil rate band. For gifts totalling more than £325,000 there is a sliding scale for tax payable by the recipients, depending on the number of years that you survive after any gifts were given.

4. Any spare change?

Excess income is anything you can spare without affecting your quality of life. You can use this to give cash amounts free of inheritance tax but make sure you keep good records of your day-to-day expenses, as well as any gifts you make. This will help executors when reporting them to HMRC and getting an inheritance tax exemption.

5. A matter or trust

A trust can be a useful way to manage assets. It’s a legal arrangement that allows you to ‘give away’ something of value without losing full control of it, and anything placed in a trust won’t be counted as part of your taxable estate when you die. You can contribute up to £325,000 tax-free every seven years. But remember, this only applies for non-exempt gifts put into trust more than seven years before death.

6. Consider life insurance

Emily says you could also think about taking out life insurance on trust to reduce any impact on your loved ones. Placing your life insurance policy in a trust means you can choose who will receive the money from any pay out. And as it would be held on trust, it wouldn’t be taxable. 

For more information

STEP offers specialist advice. For a full guide on inheritance tax, visit the gov.uk website.

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Understand how you can use your pension money – and other funds – to get the retirement you want.