A guide to Inheritance Tax
Whether you’re helping your parents make their wills, or getting your own organised, it’s worth understanding the rules so you can make the most of opportunities to save on the Inheritance Tax bill. We asked Sam Gulley of independent financial advisors Mantle FP to take us through the steps.
The following applies to England and Wales, and while the rules are slightly different in Scotland, it can still provide a useful guide.
Inheritance Tax (IHT) has traditionally been seen as a tax only for the very wealthy. However, with a threshold of £325,000 (£650,000 for married couples and civil partners) and the price of houses still relatively higher, even after recent corrections, more and more people are finding themselves caught in the net. This could lead to many people having to sell long-held family heirlooms or investment assets to meet tax bills that a little planning could help avoid.
What is Inheritance Tax?
Inheritance Tax is paid when someone transfers the ownership of their assets, usually on death. Each individual has an allowance of £325,000 known as the ‘nil rate band’, assets under this amount is free of inheritance tax.
The tax rate for all assets over the nil rate band is 40% so it is possible to build up a large bill quickly. Also it becomes payable relatively quickly and is due six months after the end of the month of death.
In addition to the £325,000 nil rate band available on each estate, transfers between husband and wife or between civil partners are free of tax. Since 9 October 2007, such legally recognised partners can also pass over any unused portion of their own nil rate band so that, in effect, the surviving spouse has up to £650,000. However, this does not apply to cohabiters or ‘common-law’ spouses.
The majority of other exemptions and allowances come about through distributing some wealth prior to death. Such transfers are termed ‘potentially exempt transfers’ (PETs) for IHT purposes and they are potentially exempt because, from the day you give them away, the tax due on death is subject to a tapering over 7 years starting at 100% of liability for the first 3 years then falling proportionally from 80% over the next 4 years. If you survive the full 7 years, the IHT liability on that asset becomes zero.
The taper relief only applies to amounts in excess of the nil rate band of £325,000, as there is no inheritance tax to be paid if the total assets are valued below this amount.
There is an important restriction on PETs called a ‘gift with reservation of benefit’. The principle is that if you continue to enjoy the benefit of the asset, the transfer is entirely ineffective for IHT. This is in place to stop parents transferring their homes to their children while they still live in them. In order for such a transfer to be potentially exempt, a full market rent would have to be paid to the children after transfer – and if anything were to happen that affected the children’s financial position, parents could find that the house would need to be sold.
Can I gift anything without being liable for IHT?
You can gift small amounts of money to family and friends without incurring any Inheritance Tax or it being a PET.
Gifts of £3,000 or less are allowed annually, and if unused, this allowance can be carried forward for one year.
There is also a gift exemption which applies to ‘regular gifts out of income’. These gifts can be as much as you like, however, they must form a ‘pattern of giving’ and HMRC must be satisfied that after the gift has been made you have sufficient income to maintain your existing standard of living.
What should I do next?
Step 1 - The Basics
Making a Will is vital. If you die ‘intestate’ (without a will), your estate will be divided up according to the rules of intestacy.
This is particularly important if you are not married, because you would be unlikely to inherit a ‘common law’ partners money or even their share of your house.
Step 2 - Use Your Allowances
The basic allowances have been described above. You should consider how you can use these in advance which will in turn help you manage the assets and any cash flow associated with a ‘pattern of giving’
In addition, you can start giving away some of your assets as PETs when you are still in good health and likely to live another 7 years. Not only will you save money in later years but will also give you peace of mind knowing you have reduced your estate.
Step 3 - Using Trusts
You can use trusts to gift money to dedicated beneficiaries to move money outside of your estate. However, you still have complete control of the gift while you are alive as a trustee and the beneficiaries will not have access to the funds without your authority or in the event of death.
Trusts are a very complicated area and there are a vast number of trusts to choose from depending on your objectives, as such you should not choose to go down this route without any financial advice. Should you wish to find more information on this option please contact an Independent Financial Advisor or a reputable solicitor who will be able to go through all of the options with you.
Step 4 - Consider Life Assurance
Life assurance can be a useful way to accumulate enough money to pay your inheritance tax bill and, when placed in trust and funded from a regular income as part of ‘pattern of giving’ is also free from Inheritance Tax. This means that you do not create an additional IHT burden, because the trust keeps that lump sum payment out of your estate and makes the money readily available to the beneficiaries in the event of death.
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