Inheritance tax is the tax on an estate, (property, money and possessions) of somebody who has died. Only a small percentage of estates are large enough to incur this tax, however you still need to understand and take it into consideration when you're putting your will together.
Today's post explains what inheritance tax is, how to work it all out and ways of reducing the amount of tax you owe.
How Much is Inheritance Tax?
As we've mentioned already, only a small percentage of estates are big enough to incur inheritance tax. Commonly, you will not need to pay any tax if:
- The value of your estate is below the £325,000 threshold.
- You leave everything to your spouse or civil partner.
- You leave everything to an exempt beneficiary such as a charity.
If you give away your home to your children, including stepchildren, adopted and foster children, this threshold increases to £425,000. This new scheme, known as the 'Main Residence Allowance' will continue to rise by £25,000 each year until it reaches £175,000 (in the year 2020). This will take the total threshold to £500,000.
In 2020, the tax-free amount will rise to £1m for couples - made up of £325,000 x two plus £175,000 x two. For singles, the tax-free amount will be £500,000 - made up of £325,000 plus £175,000.
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 your partner’s threshold when you die.
Officially, the £325,000 limit has been frozen until at least 2020/21, while the additional main residence allowance will be phased in until April 2020.
The base inheritance tax rate is currently 40%, so anything over your threshold will be taxed at this rate. The Money Advice Service provide the following example:
If your estate is worth £525,000 and your inheritance tax threshold is £325,000, the tax charged will be on £200,000 (£525,000 - £325,000). The tax would be £80,000 (40% of £200,000).
If you leave 10% or more of the net-value of your estate to charity in your will, the estate can pay inheritance tax at a reduced rate of 36%.
Inheritance tax can become tricky for unmarried couples, especially with a residential property. Your liability to pay the tax will depend on whether you and your partner own the property as 'joint tenants' or 'tenants in common', and whether there is a will.
Joint Tenants - This means that you both own all of the property. If this is the case and your partner has left you everything in the will, if your partner's assets (including the property) exceed the £425,000 threshold you'd have to pay it on any assets in the estate above that. After your partner's death, your property would then be owned by you in its entirety.
Tenants in Common - This means that you and your partner both own a specified percentage of the property. If this is the case, working out the inheritance tax is a little more complex. Money Saving Expert explain:
"If your partner's made a will leaving their share to you, any inheritance tax would be paid out of the estate by the executor before the bequests are shared out. You may end up having to pay inheritance tax on the property, but it'd depend on the value of the rest of the estate. If your partner's not made a will leaving his or her share to you, and you're tenants in common, then their share will go to your partner's relations. As an unmarried partner, you'd only be entitled to the share of the house you currently own."
It's especially important if you own a property with somebody who isn't or husband, wife or child that you make a will, in order to explain exactly who benefits on your death.
If you work in a role that is considered to be risky and day whilst in active service, you are exempt from inheritance tax. Examples include roles within the armed forces, police, fire brigade and ambulance service, as well as being a humanitarian aid worker.
The exemption also comes into play if a person who was injured on active service has their death hastened by the injury, even if they're no longer on active service.
Why do we pay Inheritance Tax?
The team over at Money Saving Expert provide the following explanation for inheritance tax:
The idea is that without it you perpetuate inherited wealth, so the children of the rich stay rich. Inheritance tax redistributes income so some of the money goes to the state to be distributed for the benefit of all. The argument against it is that when money's earned, tax is paid at the time, so to pay tax on it again isn't fair."
Inheritance tax has been moved up the Government's agenda in recent years, which is why so many changes are planned for the future - as mentioned above.
If there is a will in place, it's commonly the executor of the will who arranges to pay the inheritance tax. If there is no will, the administrator of the estate will arrange payment instead. The tax is usually paid from the funds in the estate, or from money raised from any sales of assets if the estate has no money.
In some cases, the person who dies leaves money in their estate specifically to cover the inheritance tax. For example, they could have arranged for a life insurance policy to cover this bill. Once the tax and debts are paid, the executor or administrator can distribute what remains of the estate to the heirs.
When do we need to pay?
Any inheritance tax should normally be paid within six months after the person's death. If the tax is not paid within this time, Her Majesty's Revenue and Customs will begin adding interest onto the total amount.
The executor can choose to pay for the tax on certain assets in installments over 10 years, however the outstanding amount of tax will still be charged interest. If the asset is sold before all the tax is paid, the executors must ensure that all installments (and interest) are paid at that point.
How can I reduce the cost?
There a few things that you can do to help reduce your inheritance tax. Some gifts and property are exempt from the tax, if you live for another seven years after you give them. For example, you can pass on your home to a partner or child.
If you want to continue living in your property after giving it away, you’ll need to:
- Pay rent to the new owner at the going rate (for similar local rental properties).
- Pay your share of the bills.
- Live there for at least seven years.
Of course, there are rules surrounding gift giving. It must be a genuine unconditional gift that you will not gain from, and something that has a value such as money, property and possessions. Exempted gifts that you can give away in a tax year include:
- Wedding or civil ceremony gifts of up to £1000 per person.
- Normal gifts out of your income, such as Christmas or birthday presents.
- Payments to help with another person's living costs.
Other ways of cutting your tax bill include:
- Giving away £3000 each tax year. This is completely ignored as part of your estate and therefore is not subject to inheritance tax if you die.
- Leave money to charities and political parties.
- Give £250 each year to loved ones. Gifts of no more than £250 to any one recipient per tax year are excluded from inheritance tax and are not counted toward the annual gift exemption.
- Pay into a pension instead of a savings account.
Taking out a whole of life insurance policy will help your family out when it comes to sorting out your estate after you die. Your cover can pay for some or all of the inheritance tax. Find out more about taking out life insurance today.
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