Understanding How Inheritance Tax Works in the UK

When someone passes away, their estate may be subject to a tax called inheritance tax. This tax can affect how much money or property is passed on to loved ones. Understanding how inheritance tax works in the UK is essential for planning your estate and ensuring your assets are distributed according to your wishes. This guide will explain the basics, provide practical examples, and offer tips to help you manage potential tax liabilities.

Understanding Inheritance Tax in the UK

Inheritance tax is a tax on the estate of someone who has died. The estate includes money, property, and possessions. In the UK, inheritance tax is charged at 40% on the value of the estate above a certain threshold, known as the nil-rate band. As of the current rules, this threshold is £325,000 per person.

If the estate is worth less than this amount, no inheritance tax is due. However, if the estate exceeds this threshold, the amount above £325,000 is taxed at 40%. There are some exceptions and reliefs that can reduce the amount of tax payable.

For example, if a person leaves their home to their children or grandchildren, an additional main residence nil-rate band may apply, increasing the threshold by up to £175,000. This means a married couple could potentially pass on up to £1 million tax-free by combining their allowances.

Typical UK family home

It is important to note that gifts made during a person’s lifetime can also affect inheritance tax. Gifts given more than seven years before death are usually exempt from tax, but gifts made within seven years may be taxed depending on their value and timing.

How Is Inheritance Tax Calculated?

Calculating inheritance tax can seem complicated, but breaking it down step-by-step helps. Here is a simple example:

1. Calculate the total value of the estate - This includes all assets such as property, savings, investments, and possessions.

2. Deduct any debts and liabilities - Mortgages, loans, and funeral expenses can be subtracted.

3. Apply the nil-rate band - Deduct the £325,000 threshold (or higher if the residence nil-rate band applies).

4. Calculate the tax on the remaining amount - The tax rate is 40% on the value above the threshold.

   
   

For instance, if an estate is worth £600,000 and the nil-rate band is £325,000, the taxable amount is £275,000. The inheritance tax due would be 40% of £275,000, which is £110,000.

There are also reliefs available for certain types of assets, such as business property or agricultural land, which can reduce the taxable value.

UK money representing inheritance tax calculation

Can I Just Gift 100k to My Son?

Many people wonder if they can simply gift a large sum of money, such as £100,000, to their children to avoid inheritance tax. The answer depends on the timing and rules around gifts.

Gifts made more than seven years before death are generally exempt from inheritance tax. This means if you gift £100,000 to your son and live for at least seven more years, this amount will not be counted as part of your estate for tax purposes.

However, if you pass away within seven years of making the gift, the amount may be subject to inheritance tax. The tax rate depends on how many years have passed since the gift was made:

• 0-3 years: 40% tax rate

• 3-4 years: 32% tax rate

• 4-5 years: 24% tax rate

• 5-6 years: 16% tax rate

• 6-7 years: 8% tax rate

  
  

This is known as taper relief and reduces the tax payable the longer you live after making the gift.

It is also important to note that some gifts are exempt from inheritance tax regardless of timing, such as:

• Gifts to a spouse or civil partner

• Gifts to charities

• Annual exemption gifts up to £3,000 per year

  
  

Therefore, gifting £100,000 to your son can be a useful strategy, but it requires careful planning and consideration of the seven-year rule.

Planning to Minimise Inheritance Tax

Effective planning can help reduce the amount of inheritance tax payable and ensure your estate is passed on as you wish. Here are some practical tips:

• Use your nil-rate band and residence nil-rate band allowances fully by planning your estate with your spouse or partner.

• Make use of exemptions and reliefs, such as gifting within the annual exemption limits or to charities.

• Consider setting up trusts to protect assets and control how they are distributed.

• Keep clear records of all gifts made during your lifetime to help with tax calculations.

• Review your will regularly to ensure it reflects your current wishes and takes advantage of tax planning opportunities.

  
  

Consulting a professional financial advisor or solicitor specialising in estate planning can provide personalised advice tailored to your situation.

What Happens If Inheritance Tax Is Not Paid?

If inheritance tax is not paid on time, HM Revenue and Customs (HMRC) can charge interest and penalties. The tax is usually due within six months of the end of the month in which the person died.

In some cases, if the estate includes property or assets that are not easily sold, it may be possible to pay the tax in instalments over ten years. This can help ease the financial burden on the beneficiaries.

Failing to pay inheritance tax can lead to legal complications and delays in distributing the estate. Therefore, it is important to understand your obligations and plan accordingly.

Understanding the rules around inheritance tax can seem daunting, but with the right information and planning, you can protect your estate and provide for your loved ones effectively. For more detailed guidance, visit the official inheritance tax page on the UK government website.