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There is a very common adage that nothing in life is certain other than death and taxes, and inheritance tax is a rather nasty combination of both. But it is also more than that, as inheritance tax acts as the gift tax in the UK as well, meaning there are some circumstances where you might see inheritance tax being paid without anyone actually dying. This article is intended to be the Beginner’s Guide to Inheritance Tax, kept as up to date as I can when major announcements are made.
In terms of scope, this document refers to the UK inheritance tax law, but specifically that which affects England and Wales. Scotland and Northern Ireland have somewhat different legal systems, so some of the terms in this article may not be familiar for people living there.
What Is Inheritance Tax?
Inheritance tax is predominantly the tax paid on a deceased person’s estate, but there are some very specific circumstances where it might arise without a death occurring. This guide will not be completely comprehensive, as the tax code covering inheritance tax is enormous and frankly unapproachable, but this guide will help to develop an understanding of the framework in which this tax operates.
At the heart of inheritance tax is the main rate of inheritance tax, which is set at 40%. Coupled with this are a series of allowances, most notably the Nil Rate Band of £325,000 and the Residence Nil Rate Band of a further £175,000. These allowances in particular can be inherited by a surviving spouse, so adding them up gives rise to potentially £1 million of allowance.
Importantly, the tax only applies to your taxable estate, and there are several consequences of this:
- Pensions are not taxed under inheritance tax because they do not fall into your estate (unless you do something wrong with your Expression of Wish form and the trustee pays the pension death benefits into your estate).
- Some assets are not subject to inheritance tax because they are not taxable assets. This includes unquoted shares and working agricultural land that has been owned for a minimum period.
- Some further assets might now be outside your estate, e.g. because of a gift, but count as being in your estate and therefore taxable anyway.
What is Taxable?
As a starting point, it’s best to assume that all of your wordly assets are taxable unless you have a reason to believe otherwise (and by this I mean an actual reason in law rather than just a blind belief that the millions of pounds of cash in your bank account are exempt because reasons). This means that the following things are taxable, though this is not intended to be an extensive list:
- Cash, including tax free savings accounts like ISAs.
- Investments, including share portfolios, investment ISAs, insurance bonds (unless written into trust).
- Properties, including your home, buy to let properties, holiday homes, commercial properties (unless a Business Relief exemption applies to them).
- Personal effects – watches, jewellery, collectables, etc.
- Vehicles.
When you die, it is the role of your executor (named in your will) or administrator (named by the courts if you die without a will) to gather information about your total wealth and report it back to HMRC to allow them to calculate your inheritance tax liability. As such, it make sense to maintain a record of your assets and liabilities that your executor or administrator can access after your death. For example, you might make a Google Sheets document with a list of assets and liabilities, which will assist your personal representative to understand the totality of your finances. Please note that this personal representative, whether an executor or an administrator, is legally required to disclose all of your finances to HMRC, with a strict penalty if they are found to have misled the authorities, therefore it is a very good idea to make it as easy as possible to fully understand your position.
Importantly, your estate at death is not just what you physically own at that time. It also accounts for most gifts made in the last 7 years of life. This means that the personal representative must look into your history of gifting and provide that information to HMRC along with your current estate value. For that reason, I would generally recommend that people maintain a list of gifts they make and keep it in a place that their personal representative can access. For those with a will, it makes sense to keep this alongside the will, wherever that is kept.
There are a few things which can be deducted from the value of your estate when calculating the inheritance tax liability. Usually this is debt, assuming the debt does not die with the deceased. As an example, a property worth £300,000 with a £100,000 mortgage would be counted as an asset worth £300,000 and a deductible liability of £100,000 for a total taxable value of £200,000.
What is not Taxable?
From this, you will see already that there are a staggering number of things that are taxed, so assets which are not taxed feel very much like the exception rather than the rule. That said, there are some very important exclusions which will affect you to a greater or lesser extent. These are:
- Pensions
- Exempt Assets
- Gifts made more than 7 years ago
- Gifts that used a statutory allowance
- Assets within your Nil Rate Band (including any available Residence Nil Rate Band)
Pensions are generally structured as trusts, meaning the holdings do not form part of your estate and can be paid to your heirs without any calculation of inheritance tax. There are some schemes which are set up poorly, in that the death benefits are paid to your estate, but these schemes are getting very rare these days. That said, it is always important to check your pension scheme’s death benefits and to make sure that your Expression of Wish form is up to date. If you want to find out more about pensions, I have a Beginner’s Guide to Pensions as well.
I have a section below on Exempt Assets. Generally these are either unquoted companies or farmland, so the intention in law is to reward risk taking, so it is always worth bearing in mind that this type of exemption is supposed to be fairly high risk.
Gifts
As already mentioned, there is no specific gift tax in the UK, instead gifts are covered by the Inheritance Tax provisions. When looking at gifts, there are essentially 3 types to consider:
- Statutory gifts using one of the gift allowances.
- Potential Exempt Transfers.
- Chargeable Lifetime Transfers.
The statutory allowances are mostly small amounts. There is a general allowance for small gifts of £250 or less, and a larger allowance of £3,000 for gifts made in excess of this. The £250 allowance is per recipient per year, while the £3,000 allowance is for the donor and can be rolled up by a year if unused, though after that it is lost. In addition to these, there are a series of allowances that can be used where a gift is made in celebration of a wedding, with the amount varying depending on how closely related the donor is to the recipients.
Perhaps more interestingly from a financial planning perspective is the regular gifting allowance. This allows any gifts made habitually and from excess income rather than capital to be immediately exempted from consideration for inheritance tax without limit. This means that if you have £10,000 excess income each year, you can gift that away to your heirs on their birthday and these gifts will never fall back into your estate for inheritance tax planning purposes. Importantly, these gifts must be made from excess income. If you need to tap into your capital in the same year as making such a gift, it will likely not be allowed.
Potentially Exempt Transfers (PETs) represent the most normal gift regime once the statutory allowances have been exceeded. The general rule for a PET is that the transfer takes place without tax, but a timer starts from the date of the gift. If the donor survives for at least 7 years, no tax is ever due on this gift. If they die within 7 years, the gift falls back into the estate and the tax is calculated as though the gift hadn’t been made,with a small exception. If the gift used up the entirety of the Nil Rate Band (see below), then a tapering applies to the calculated tax for gifts made more than 3 years prior to death. Taper relief on inheritance tax is generally very poorly understood, but the very simple consequence is that unless you are making gifts in excess of your Nil Rate Band, you likely will never benefit from tapering of your inheritance tax.
If you make a gift to a discretionary trust rather than a person, you might instead fall into the Chargeable Lifetime Transfer regime. For gift made within the Nil Rate Band, these distinctions likely don’t mean much, but once you cumulatively exceed the Nil Rate Band in a given 7 year period, the treatment is rather different. For such gifts, there is an up-front payment of half the main inheritance tax rate. At the moment, that means 20%. If death occurs within 7 years, the tax due is calculated but the initial payment is then subtracted from the owed amount.
Nil Rate Band
Probably the most well-known allowance for inheritance tax is the Nil Rate Band. This is essentially the amount of money you are allowed to bequeath on death without any inheritance tax being due. At the moment the amount in question is £325,000 per person. Until relatively recently, it was not possible to pass on unused allowance to surviving spouses, but this has now been amended, meaning a husband and wife can have a combined allowance of £650,000. Do note that it is not possible to inherit more than 1 additional Nil Rate Band even if you have been unlucky (or lucky) to have survived multiple spouses.
Because of this change there is a significant amount of planning that was set up when the Nil Rate Band wasn’t transferable, and if your will still includes provision for setting up a family trust on first death, that may no longer be necessary and it may therefore warrant looking at your will with a solicitor or will writing professional.
As an example of how this works, if a husband and wife die with an estate worth £800,000 having made no gifts which eat into the Nil Rate Band, the inheritance tax position is as follows:
|
Item
|
Value
|
|---|---|
|
Gross Estate
|
£800,000
|
|
less Nil Rate Band x2
|
-£650,000
|
|
Taxable Estate
|
£150,000
|
The available Nil Rate Band on death is used up by non-exempt gifts from the last 7 years before any remaining estate. This means that, for example, you could make a gift of £200,000 and it would count against your Nil Rate Band in full for the next 7 years.
Residence Nil Rate Band
The Residence Nil Rate Band is an additional allowance of £175,000 per person that adds to your normal Nil Rate Band. In order to claim this, however, there are a number of requirements:
- Your estate must include your family home or the proceed thereof.
- The home or its value must pass to your lineal descendants. This generally means children and grandchildren and so on, but specifically excludes siblings, nephews and nieces, cousins, etc.
- Your estate must be sufficiently small so as not to lose the allowance through tapering.
The tapering of the Residence Nil Rate Band happens when your estate is in excess of £2 million. At that point the allowance is reduced by £1 for ever £2 of value over the threshold. This means that for a single person the allowance is withdrawn when the estate reaches £2,350,000, while for a joint estate with inherited allowances the point is £2,700,000.
This does lead to an interesting planning opportunity, as the tapering is based on the absolute value of your estate at the point of death and specifically does not include gifts made at any time in the past. As such, it is possible to reclaim some or all of the Residence Nil Rate Band by making a gift that is almost certain to fail for inheritance tax purposes (i.e. your life expectancy is under 7 years).
Charitable Bequests
There is a little-known quirk to inheritance tax calculation, stemming from the fact that if you leave 10% of your taxable estate or more to charity, the main rate of inheritance tax on the remaining estate is reduced to 36%. The quirk arises from the fact that this leaves a band of charitable bequests which don’t make much sense mathematically. The table below summarises the situation:
What this means is that if you make a gift of between 4% and 10% to charity, your heirs would actually be better off if you increased that gift to 10% due to the tax reduction on the remainder of the estate. In essence, gifting between 4% and 10% of your estate to charity on death is inefficient.
It is unlikely that anyone sets out to give an inefficient amount to charity, but it can happen easily. For example, if you draft a will that leaves 10% of your taxable estate to charity, but make the mistake of calculating that in pounds and pence and specifying it as such (e.g. “I leave a gift of £100,000 for the local donkey sanctuary”) then a change to the value of your estate as a whole can have a very serious impact on the calculation of your gift as a percentage.
It is also worth being aware of how percentages and named sums interact within your will. For example, if you leave your neighbour £5,000 and want to make a charitable gift of 10% to ensure the rate reduction, it is vital to ensure that the 10% is calculated before the deduction of the £5,000 gift. Otherwise it might be calculated as 10% of the estate after making the bequest to your neighbour, which would end up being under 10% of the taxable estate.
Inheritance Tax Mitigation Strategies
Inheritance tax is often referred to as “essentially optional” once you get to a certain estate size. This is due to a combination of allowances and mitigation strategies, and is directly responsible for the UK’s inheritance tax take making up only around 0.7% of the annual tax revenue raised despite being a very hefty 40% tax. Without going into either the politics or the ethics of taxation as a whole, the important message is that the system has been set up such that these mitigation strategies are available if you want to make use of them.
From my own perspective, I have views on how inheritance tax should work, and you can read more on my political website, but professionally my job is to work within the system that currently exists and advise people on their options.Â
Do Nothing / Spend It
As a first principle, it is important to remember that money you spend on yourself falls out of your estate immediately. If you have a significant estate, this essentially means that every £1 you spend on yourself means your estate pays 40p less inheritance tax. This is a great deal, essentially granting you tax relief on pretty much everything you choose to spend money on.
This approach has also been referred to as “SKIing” – Spending the Kids’ Inheritance. This is quite a funny interpretation, but it runs the risk of falling into a common trap. Your money is yours. If you have some left over when you die, then it can become the kids’ inheritance, but until then it is yours. The adage that I tend to use here is stolen from airline safety briefings, namely “affix your own mask before helping others”. In this case, the analogy means that you should use your wealth to look after yourself first. After all, many people thinking about inheritance tax planning are at a stage in life where if they give away too much of their net worth, they cannot replace it.
This should always be the starting point for discussions about inheritance tax. Start with the question “what if I just spend it on myself?” and think through what the consequences would be.
In many cases this will help identify surplus assets which can be the subject of further discussions about other mitigation strategies.
Gifting
As already mentioned above, there is no limit to the size of gifts you can make to your heirs at any time. The tax treatment will depend on the size of the gift and the recipient’s status (almost all gifts made to specific people will qualify as Potentially Exempt Transfers). Importantly, making a gift in excess of the statutory allowances will potentially have consequences for 7 years, potentially up to 14 years if you make a series of both Potentially Exempt Transfers and Chargeable Lifetime Transfers in the wrong sequence. As such, it is important to remember that in most cases making a gift is not the end of the risk but instead represents the start of a 7-year countdown.
It is also worth remembering that gifting an asset counts as a disposal for Capital Gains Tax purposes. This means that there may be up-front tax due if, for example, you give away a portfolio of shares that you have held for many years, and the CGT due will be calculated as though you had sold the shares at market value.
Allowances
As mentioned above, there are a series of allowances that can be used by anyone, but they are relatively modest in comparison to the size of estate that tends to trigger inheritance tax. That said, these allowances should always be considered when constructing a gifting strategy, as they are available for free and can cumulatively make quite a difference.
Outright gifts
Most gifts made outright to a named recipient will qualify as Potentially Exempt Transfers, meaning no inheritance tax is due at the point of transfer. When such a gift is made, it will instead trigger the start of a 7-year clock, and if death occurs within that time the gift will be deemed to have failed to leave the estate.Â
It is possible to take out an insurance policy against the effects of this failure. This involves taking out a Level Term Assurance policy for the inheritance tax that would be due on your estate as a result of losing a proportion of the Nil Rate Band. If the calculated Potentially Exempt Transfer was £100,000, for example, that means £100,000 of the Nil Rate Band would be unavailable for the rest of the estate to use, potentially adding £40,000 of tax. As such, the donor might consider taking out a 7-year policy with a sum assured of £40,000. This likely costs far less than the impact of losing that Nil Rate Band, making this a very suitable option for most people making large gifts.
Gifts into trust
Discounted Gift Trust
Lending
Outright lending
Loans to trust
Exempt Assets
Looking back at the “What is not Taxable?” section, you can see that some assets are not subject to inheritance tax even though they still sit within your estate. One mitigation strategy is therefore to deliberately invest your estate’s wealth into assets which do not attract inheritance tax.
Exemptions like this are not particularly common, but nor are they restricted to either a limit per person or an overall limit to the value of the exempt asset market. In general, these exemptions fall into one of 2 categories:
- Business Relief
- Agricultural Relief
There is a third category of Woodland Relief, but this importantly is a tax deferral mechanism rather than a full exemption, hence I have not included it in this section.
Business Relief
Business Relief is designed to provide relief for small, usually family-owned businesses, but due to various methods of interpreting the intent of law, it now applies to any company which does not trade its shares on a main stock exchange. This gets quite technical, but the ultimate outcome is that shares which are traded on the UK’s secondary exchange – the Alternative Investment Market – are considered to be unquoted shares for the purpose of this exemption. Although this was meant to capture only smaller companies, there are now several companies worth more than £1 billion trading on the AIM rather than the London Stock Exchange.
Business Relief is applied by reducing the rate of inheritance tax after a minimum holding period. There are a number of permutations in law, but for most individuals the most important figure is 2 years, in that the cumulative time that you own exempt assets for must exceed 2 years in the last 5 for the exemption to apply. At the time of writing, if you have held qualifying assets for the minimum qualifying period you benefit from 100% reduction in inheritance tax.
If you do not meet one of the criteria – usually that means not owning the assets for long enough – then no exemption is available and the full value is taxable. There is a “replacement property” rule which allows you to account for prior ownership of exempt assets. This means that if you sell a business that would qualify for Business Relief, but then soon after invest into a portfolio of unquoted shares, you can use the replacement property rules to reference your ownership of your company as part of your qualifying holding period for the unquoted shares, meaning you might be able to get immediate exemption.
Agricultural Relief
Agricultural Relief is analogous to Business Relief, in that it is intended to allow family owned farms to pass down the generations without being taxed. There are some investment companies offering access to farmland, but there isn’t an equivalent of the AIM exchange, so these investments tend to be larger and much less liquid.  This means it is far less common to see Agricultural Relief sought from smaller estates, though it is certainly not unheard of for families that own a paddock used for grazing. That said, if you do not already have a farm or a connection to farming, it is much less likely that you will make use of Agricultural Relief rather than Business Relief.
Insurance Against Inheritance Tax
NRB Insurance
Gift inter vivos
Whole of Life cover
Keeping Things Tidy
Wills
Lasting Powers of Attorney
