What is inheritance tax? And how much could it cost you?

Many people may not be aware of how their main home and other assets could be affected by inheritance tax (IHT) after they’ve passed away. We explore some of the key things to know about IHT and options you may want to consider to reduce your potential IHT bill.

Inheritance tax has been described as a ‘voluntary tax’ in the past because of the perception that you can take steps to either reduce your tax bill or avoid paying it through tax planning.

However, a combination of frozen tax thresholds and rising inflation means that more ordinary families are paying the 40% tax than ever before, leading some to suggest that it should be abolished altogether.

It has been argued that IHT is unfair, easy to avoid and pushes up house prices. However, it is a significant revenue-raiser for the government, with the most recent figures suggesting the tax take is rising by 9.1% a year.

Arguments surrounding the tax look set to drag on, but that is no reason to delay your own inheritance planning, which could help your loved ones to inherit significantly more of your estate in the future.

How does inheritance tax work and who pays it?

When someone dies, inheritance tax is charged on their estate at a rate of 40% of the value of assets above a certain threshold (we outline this below). It is paid out of the deceased’s estate, rather than by the beneficiaries who inherit from it, and the executor of the will is responsible for sorting it out.

The current ‘nil-rate band’ for IHT, below which there is no tax to pay, is £325,000. This threshold has been frozen for 14 years, while house prices and wages have risen. That means many more families are finding that estates are liable for the tax, hence some of the disquiet about whether or not it is fair.

However, as well as the £325,000 threshold there is a separate Main Residence Allowance, meaning that you can pass on your home to your children (including adopted, foster or stepchildren) or grandchildren and there will be no tax to pay on the first £175,000 of its value. Your overall allowance for IHT could therefore increase to £500,000 when including the value of your home.

When a spouse or civil partner dies, the estate can be transferred between the couple without incurring any IHT, and they also inherit both the nil-rate bands for the whole estate and for the main residence. Because of this, some families can pass down an estate worth a total of £1 million without paying any IHT.

If you’re married or in a civil partnership and your estate is worth less than your threshold, any unused threshold can be added to that of your partner when you die.

If IHT is due, it must generally be paid six months after the person’s death. If not, HMRC can start to charge interest on the tax owed. If assets such as property need to be sold to pay the bill, the tax can be paid in instalments over a 10-year period, but interest will apply.

Inheritance tax – what’s taxed?

You might think you know what your ‘estate’ is worth, but not all your assets are counted as part of your estate for IHT purposes.

Almost everything, including money in the bank, any investments and property you own, and even some gifts you have recently given away, is counted when totting up its value. However, your pension is not included in this figure, even if you have taken some money out of it via drawdown or through a tax-free lump sum.

All this means that investors, as well as those who have the bulk of their money in property, need to understand how IHT works and plan for it. It also means that your pension is potentially a very valuable way of passing wealth down to the next generation.

Knowing this could affect the way you structure your investments and your retirement spending to maximise the benefit to your family.

Reducing your family’s inheritance tax bill

There is currently no sign of IHT becoming a thing of the past. That means that you may want to consider making plans to ensure that your own family pays as little of it as possible, so you can leave a legacy for the next generation.

Ways to protect your estate from IHT may include:

Giving money away while you are alive

Money or assets that are given away more than seven years before you die are not counted as part of your estate for IHT purposes.

You can also make use of an annual allowance to give away money each year that will not be included in IHT calculations, even if you die before seven years is up.

Leaving assets to a spouse

As mentioned above, leaving your estate to a spouse or civil partner does not attract IHT and allows them to inherit your IHT allowances, increasing their ability to pass down money later.

Leaving your main home to close relatives

The main residence nil-rate band adds £175,000 to the untaxed portion of your estate, but only if you leave your home to a child or grandchild.

Investing using a pension

Assets remaining in your pension are not counted as part of your estate for IHT purposes and can be passed down to your children or other beneficiaries IHT-free.

Giving to charity

By giving money to charity, you can reduce the IHT bill and support a cherished cause at the same time. Not only are gifts to qualifying charities exempt from IHT, if you leave at least 10% of your net estate to charity the rate at which you pay IHT on the remainder is also reduced to 36%.

Using trusts and life insurance policies

Some types of trust can be used to help save on IHT, with the benefit of being able to control and protect family assets and leaving a gift to a loved one, while some people choose to take out life insurance policies that can mitigate the effect of the tax.

How to find advice on inheritance tax planning

If you are concerned about IHT and want to talk about how to arrange your money in the most efficient manner, a financial adviser will be able to help you make plans. It is also a good idea to update your will at the same time as thinking about IHT.

For other issues, Nutmeg also offers a restricted financial advice service, available for a one-off fixed fee of £575 (including VAT), though tax advice and will writing is not included. We also offer a free financial guidance service. If you would like to discuss your financial goals, you can book a free call with one of our experts.

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. The above does not constitute tax advice or recommendations. Tax treatment depends on your individual circumstances and may be subject to change in the future.