Inheritance Tax Explained
What is IHT?
IHT, short for Inheritance Tax is a tax introduced by the Inheritance Tax Act 1984. It is argued that IHT is a tax on wealth because anyone with an estate worth over £325,000 will have to pay Inheritance Tax on their death, hence why it is also referred to as the death tax. It is important to note that IHT is charged on wealth that is given or distributed on death and on gifts made prior to the testators death (7 years prior).
When is it paid?
IHT is calculated and paid to HMRC after the death of the testator when administering the estate but may take into account gifts made during the testator’s lifetime. It does not need to be paid instantly as HMRC understand that the estate may not have liquid assets to pay the tax on death. Any IHT due on an estate must be paid by the end of the 6th month of the person’s death.
How is it calculated?
IHT is charged at 40% on anything over £325,000 of the testators estate except under certain conditions explained below (See PET and CLT). If the testator’s estate (property, money and assets) is worth less than £325,000 then no IHT will be payable.
The £325,000 allowance is known as the Nil-Rate Band owing to the band of the clients estate where no tax is payable.
For example if someone died today (Jan 2017) with an estate worth £400,000 then they have an allowance of £325,000 so £75,000 would be taxable at 40% meaning £30,000 would be payable to HMRC.
The rate of IHT payable is reduced to 36% if at least 10% of the net estate is left to charity.
The Transferable Nil-Rate Band
If a testator doesn’t use up their full £325,000 allowance on or by their death then this is transferable to their spouse or civil partner. This simply means that when the testator’s spouse passes away they could potentially benefit from two Nil-Rate Bands (£650,000). Anything over and above this figure would be taxed at the 40% rate.
Using the example above (£30,000 tax bill) it is easy to understand why people would want to plan to ensure that their estate is passed onto their intended beneficiaries free of IHT. Therefore paying a professional adviser a small percentage of this figure is often considered acceptable.
There are methods used to mitigate IHT and these are detailed below:
Potentially Exempt Transfer (PET)
A testator can make gifts during their lifetime which will be exempt from IHT if they survive for a period of 7 years.
Chargable Lifetime Transfer (CLT)
Gifts made into a trust rather than to an individual may benefit from a reduced rate of tax. Such a gift, known as a chargable transfer is taxed at 20% on entry into the trust. It will then be taxed on 10 yearly anniversaries and when assets leave the trust. These anniversary and exit charges will be a maximum of 6%.
Fully Exempt Transfer (FET)
Gifts to spouses or civil partners are exempt due to the spouse exemption (section 18 of the Inheritance Tax Ac 1984). If a client died and left their spouse £1,000,000 then this would be free of IHT. The consideration would then be how much IHT the surviving spouse would pay on their death.
From April 2017 you may also benefit from the Residential Nil-Rate Band (RNRB). which can be set against the value of a residential property (or a share of one) where the homeowner leaves it to their children or grandchildren (including stepchildren, adopted children and foster children). The additional tax free amount will start at £100,000 in 2017 and will increase by £25,000 a year until 2020/21 when it reaches £175,000 per person. This means that couples and civil partners will be able to pass up to £1,000,000 to their children tax-free by 2021.