What is inheritance tax and how does it work?

Navigating inheritance tax is vital for efficient wealth management and financial planning in later life.

Whether you just want to know the basics or hope to gain insights to improve future strategy, understanding inheritance tax can offer peace of mind for you and those who might inherit your estate.

Below, we’ll discuss what inheritance tax is, who needs to pay it and how it works.

The basics: what is inheritance tax?

When someone passes away, their assets – whether property, money, or other possessions – may be subject to inheritance tax.

Several factors will influence an individual’s inheritance tax liability.:

1. Value of the estate

Inheritance tax kicks in when the value of the deceased’s estate exceeds the tax-free threshold of £325,000. Anything above this threshold is usually taxed at a standard 40% rate.

For instance, if the deceased had an estate valued at £400,000 and no other exemptions apply, only £75,000 of it is taxed at the 40% rate.

2. When and how is inheritance tax paid?

Inheritance tax becomes due within six months after the individual’s death. If the bill is not settled within this timeframe, HMRC will start charging interest.

This responsibility lies with the executor(s) of the will or the legal representative(s) overseeing the estate’s distribution. There are a few different ways to make these payments, including:

• by approving through your bank account
• via bank transfer
• using telephone banking
• at a branch of your bank or building society
• by cheque through the post.

In some cases, you may need to liquidate the assets to cover the inheritance tax due.

3. Exemptions

There are several exemptions and reliefs that can help minimise your inheritance tax liabilities.

1. Spouse or civil partner exemption: If the deceased leaves everything to a spouse or civil partner, there’s usually no inheritance tax payable.
2. The seven-year rule: If you gift money or assets less than seven years before your death, they may be subject to inheritance tax on a sliding scale known as ‘taper relief’. However, gifts made more than seven years before your death aren’t usually counted towards the estate’s value.
3. Charitable donations: If somebody leaves 10% or more of the estate’s net value to a charity in their will, a reduced inheritance tax charge of 36% will apply.
4. Direct descendants: Leaving your main residence to your children or grandchildren can increase your tax-free allowance by £175,000 to a total of £500,000.

Strategies to minimise inheritance tax

No one wants to pay more tax than they need to, and you’ll likely want to leave your loved ones with as much as possible. The good news is that minimising your inheritance tax bill is perfectly reasonable and legal if you know how to stay compliant.

Here are a few ways you can legally reduce the inheritance tax payable on an estate.

Distribute your wealth early

Gifting assets during your lifetime can improve your inheritance tax position, as you can give away up to £3,000 each year completely tax-free. By distributing wealth in this manner, you can reduce the value of your estate and your inheritance tax liability as a result.

Charitable contributions

Leaving 10% or more of the value of your estate to charity can reduce the inheritance tax rate from 40% to 36%. In addition, any amount that you leave to charity will be exempt from inheritance tax.

Trusts

Holding your assets in a trust can reduce your overall inheritance tax bill and give you more control over how funds are used and distributed. The tax treatment of trusts can be complicated, however, so you should always speak to a financial adviser before using one.

Tapered relief on gifts

If you make a gift less than three years before your death, the standard 40% inheritance tax rate will apply, while gifts made more than seven years prior to your are completely exempt. So what about the time in between? That’s where tapered relief comes into play.

Here’s how it works:

• 3 to 4 years before death: 32%
• 4 to 5 years before death: 24%
• 5 to 6 years before death: 16%
• 6 to 7 years before death: 8%.

Summary

Inheritance tax, while a critical aspect of wealth management, can seem intimidating – especially if you’re trying to reduce tax on your estate. But with the right guidance and expertise, it’s possible to navigate these complexities efficiently.

At Bulley Davey, we put clients first. We’ll focus on your needs, tailoring our estate planning advice and inheritance tax strategy to your unique circumstances.

Get in touch to discuss your estate planning strategy.