It is never too early to start inheritance tax planning (IHT). Early planning will allow you to take advantage of all the allowances and facilities available to protect your assets and to pass them on to your children, grandchildren, or whomever you choose.
Over the course of many years you will have built up your wealth and accordingly paid income tax, so you do not want to pay another round of tax. You certainly do not want your children to be forced to sell the family home to pay an inheritance tax bill!
What will happen if you have no plan?
Anything you leave behind over £325,000 (this figure is called the nil rate band) will be taxed at 40%. An additional nil rate band applies to your residence (family home) which will be taxed separately. The nil rate band applicable to residences is currently £125,000 and will increase yearly to £175,000 in 2021. The figure starts to reduce however for high value residences (over £2m).
Importantly, you can pass on anything to your spouse IHT-free. The nil rate bands themselves pass on to the surviving spouse (this does not include any ex-spouses). Your surviving spouse will have nil rate band of £650,000 when they die, if none has been used.
Example – Total nil rate band for two married parents with children in 2021
The applicable nil rate bands for married parents will be:
- £325,000 nil rate band for first parent
- £325,000 transferable nil rate band for second parent
- £175,000 nil rate band for family home (this tapers off for homes worth more than £2m)
- £175,000 transferrable nil rate band for family home for second parent
The total combined nil rate band for both parents:
- £1m in total by 2021 for family home
Let’s assume the married couple has a family home worth £1m in 2021 and has not used their nil rate band. If they have left no other assets their home will be totally covered by their combined nil rate band, and no IHT will be payable.
Alternatively, when you have more than the family home to pass on, the simplest way to save inheritance tax is to take advantage of the various exemptions available.
- Annual exemption. You can give away £3,000 per annum. This can be to one or multiple beneficiaries without them incurring IHT. It can only be carried over to the next tax year but only to a maximum of £6,000. In another words, you can not accumulate several years’ worth of allowance and make a big gift in one year. If you give away more than £3,000 in a tax year and die within seven years, the amount over £3,000 will be taxable.
- Small gift exemption. You can give away a maximum of £250 per annum to as many individuals as you like. But you can not add this to the £3,000 in point 1. It means you can give individual A £3,000 per annum, and individual B £250, but you can not give individual A £3,250. In addition, if you give £251, the whole amount will cease to be exempted gift, not only the £1 above £250.
- Give money to your beneficiaries as normal expenditure out of income. These are in effect gifts, and must be regular, habitual, out of income (instead of capital), and must not cause your living standard to suffer as a result. For example, you may choose to pay you child a regular monthly allowance of $1,000 funded by your regular income. This amount would be tax exempt.
- Wedding gift exemption:
- £5,000 per child (and step child, adopted child) per parent
- It must be given before the wedding
- It is in addition to the £3,000 annual exemption
- £2,500 per grandchild per grandparent
- £1,000 for anyone else
- £5,000 per child (and step child, adopted child) per parent
Even if the amount that you give to your beneficiaries exceeds the exemption, your beneficiaries will gift, it becomes fully exempt from IHT. During that 7-year period, the gift from you is known as Potentially Exempt Transfer (PET). However, in the unfortunate scenario that you do not survive for 7 years after making the gift, the gift becomes part of your estate, and is therefore subject to IHT. The applicable tax rate for IHT is based on the 7-year rule (taper relief). According to this rule, gifts given more recently are taxed more heavily than given further back in the past.
Here is a more complex example with all the factors described above involved.
Lucy gave the following gifts since 2013:
- To John, Lucy’s step-son – cash of £15,000, on 2 May, 2013
- To Charlie, Lucy’s husband – a set of jewellery worth £8,000, on 9 October, 2014
- To Maggie, Lucy’s daughter – Aviva shares valued at £30,000, on 18 June, 2015
- To Bob, Lucy’s nephew – an antique vase, valued at £20,000, on 20 September, 2017
- To Ann, Lucy’s sister – a piece of land valued at £15,000, on 3 August, 2018
Lucy passes away on 20 April, 2021. She passes the family home worth £950,000 to her daughter Maggie.
Lucy’s husband died on 10 December, 2015. He used £50,000 of his nil rate band.
IHT liability
The gift to John was made more than 7 years before Lucy’s death. No IHT is due.
The gift to Charlie was between spouses. No IHT is due.
For Maggie the daughter
- The family home will be entirely covered by the extended nil rate band:
- £325,000 (Lucy) + £175,000 (Lucy) + £325,000 (Charlie) – £50,000 (Charlie) + £175,000 (Charlie) = £950,000
- Two years’ annual exemption can be used to reduce the taxable amount of the Aviva shares, as the 2015 exemption was not used and can be carried over to 2016.
- Taxable amount is £30,000 – £6,000 = £24,000
- Based on the 7-year rule, and because the gift was made 6 years ago, the applicable rate is 16%. IHT due will be: £24,000 X 16% = £3,840
For Bob the nephew
Two years’ annual exemption can be used to reduce the taxable amount of the vase, as the 2017 exemption was not used and can be carried over to 2018.
- Taxable amount is £20,000 – £6,000 = £14,000
- Based on the 7-year rule, and because the gift was made less than 4 years ago, the rate to use is 32%. IHT due will be: £14,000 X 32% = £4,480
For Ann the sister
One years’ annual exemption can be used to reduce the taxable amount of the land.
Taxable amount is £15,000 – £3,000 = £12,000
- Based on the 7-year rule, and because gift was made less than 3 years ago, no IHT relief is applicable. IHT due will be: £12,000 X 40% = £4,800
More reliefs and tools are available for IHT planning. These will be explained in the future articles.