Unsure about Inheritance Tax?

The basics of Inheritance Tax and the areas this section will cover

Are you unsure about Inheritance Tax?. The basics of inheritance tax are quite straightforward. If you are either already on the journey towards prosperity or just about to start it you will need to get at least some understanding of Inheritance Tax. 

After all, the purpose of making the journey towards prosperity is not just (or even) so that you can enjoy a prosperous life but that in so doing you can bring prosperity to your loved ones and others as well.  This can be both during your lifetime and after your death.

So being aware of a tax that may take a large portion of the funds earmarked for others on your death (and even during your lifetime) is only good sense, especially as steps can be taken to reduce its impact or remove it all together.

The background to Inheritance Tax

Probate duty – was introduced in 1694, in order to help finance England’s involvement in the Nine Years War against France. It originally applied to all probates of wills and letters of administration for personal estates valued greater than £20, at a fixed duty of 5 shillings (i.e. 25p).

It was converted into a graduated rate in 1780 to finance our activity in the American War of Independence.

Estate Duty – was introduced in 1894.  Estates over £100 were charged at 1% and then on a sliding scale to estates over £1m charged at 8%.  It became more highly progressive over time.

Capital Transfer Tax – was introduced in 1975 by the Labour Chancellor, Denis Healey.  This was a tax on lifetime gifts and not just those at death.

Inheritance Tax – was introduced in 1986 by the Conservative Chancellor, Nigel Lawson.  It abolished tax on lifetime gifts apart from those made within seven years of death.

When the tax was first introduced it was intended to affect only the very wealthy, but the rise in the value of homes has brought more families into the net in recent decades.

How much tax is collected?

In the following table ‘net estate’ is assets plus gifts within the last 7 years less liabilities

It is expected to change!

Further to a request by the Chancellor in January 2018, The Office of Tax Simplification (OTS) has recently produced its Inheritance Tax Review – second report: Simplifying the design of Inheritance Tax

To quote from this report ‘The OTS’s extensive consultation exercise revealed many areas where Inheritance Tax is either poorly understood, counter-intuitive, requires substantial record keeping, creates distortions, or where the application of the law is simply unclear.’

The OTS has made 11 recommendations which will generally be welcomed if enacted.  We will refer to some of these where applicable.

Inheritance Tax (IHT)

Inheritance tax is a tax on your estate – your estate includes everything that you own or control at your death.  It is a combined gift tax and death duty.  In simple terms it is a tax charged on the property you own or control when you die, including any gifts you make in the seven years before your death.

Inheritance tax is payable at the rate of 40% on all estates worth more than the inheritance tax ‘nil rate band’ of £325,000 (2020-2021).

The late Lord Jenkins of Hillhead, former Chancellor of the Exchequer in a 1986 commons debate stated ‘Inheritance tax is, broadly speaking, a voluntary levy paid by those who distrust their heirs more than they dislike the Inland Revenue!’

Seven year rule – the provisions of the tax allow you to give away your accumulated wealth and, by surviving for a further seven years, for that gift to become exempt from IHT.  This provides you with an opportunity to make prudent plans for your estate in order to reduce the burden of IHT for your beneficiaries.

OTS recommendation is to reduce the 7 year period to 5 years so that gifts to individuals made more than 5 years before death are exempt from IHT.

Married/Civil Partnership

Spouse Exemption – if you are married or in a civil partnership, the assets you leave to your spouse will be transferred without any inheritance tax to pay.  Also, leaving assets to your spouse does not use up any of your nil rate band.  For this purpose a couple is regarded as married or in a civil partnership until a decree absolute has been obtained.

Widowed – when someone dies, their unused nil rate band can be transferred to their spouse or civil partner.  So, for example, if your spouse left everything to you on their death you could potentially have a combined nil rate band of £650,000 applied to your estate.  If your spouse had used half of her nil rate band then half of the current nil rate band is available to your estate on your death.

Unmarried couple – treated as single for IHT purposes so the nil rate band cannot be combined on death.

The exemption is restricted where a UK domiciled spouse makes transfers to a foreign domiciled spouse.    For IHT purposes an individual will be deemed to be UK domiciled for a tax year if he or she has been resident in the UK during 17 out of the 20 tax years that end with the current tax year.  As these do not have to be complete years the shortest period is 15 years and two months.

Where your gift is to a foreign domiciled spouse the exemption is limited to the Nil Rate Band.  If you are domiciled outside the UK and your spouse in domiciled in the UK then the £325,000 limit does not apply.

The restriction applies to the cumulative total of all transfers to a spouse or civil partner. So you must take into account the amounts allowed under earlier transfers to a spouse or civil partner whether or not they were domiciled in the UK at the time.  If you have been married previously the restriction applies to the cumulative total of all transfers to all spouses or civil partners.

Only two nil rate bands are available on a person’s death no matter how many former spouses they have had.  If a widow remarries it would make sense for her to leave at least the nil rate band to other than her new husband should she die first.  In this way three nil rate bands could be used as her new husband will still be able to claim her unused nil rate band on his death.

Residence Nil Rate Band

The residence nil rate band (RNRB) applies to the estates of people who die after 6 April 2017.  It does not matter whether the first spouse died before that date. It only applies if you plan on leaving a residence to ‘direct descendants’ such as your children or grandchildren and their spouses.

Anyone who disposed of their property before 8 July 2015 – for example because they are in residential care or living with their children – will not benefit from the residence nil rate band at all.

The RNRB is £175,000 per person (2020-2021).  The maximum nil rate band for a widow/widower leaving a residence to children or grandchildren is therefore £1 million (i.e. £325,000 + £325,000 + £175,000 + £175,000).

Larger Estates – the residence nil rate band will be reduced by a rate of £1 for every £2 by which their estate exceeds £2 million.

Maximum claim – limited to the lessor of the allowance at the time of the second death and the value of the home owned by the deceased.

Inflation – from 6 April 2021 both the nil rate band and the residence nil rate band will increase in line with inflation (Consumer Prices Index).


Links to more information

Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.