How does Inheritance Tax work?

What is Inheritance Tax?

Inheritance Tax (IHT) is a tax which may be paid on your estate (your money, possessions and your share of any property) when you die. This reduces how much value will ultimately pass to your beneficiaries. Your beneficiaries are the people you want to leave your money and assets to when you die.

Inheritance Tax may also be payable on certain gifts you make while you are still alive. We'll cover that in more detail later in this guide.

What is the Inheritance Tax threshold?

In the current tax year, 2024/25, IHT is applied to estates worth more than £325,000 - though this threshold is likely to change in future. When the value of your estate exceeds the limit, known as the 'nil-rate band', everything over the threshold is taxed at 40% (unless you're leaving it to your surviving spouse, in which case, usually, no IHT needs to be paid).

The tax is levied on the worldwide assets of 'UK domiciled individuals' (people whose permanent home is in the UK). It also applies to the UK assets of people who live abroad.

That means if you're a UK citizen and you have a holiday home abroad, it still counts as part of your estate for IHT purposes. Similarly, if you're a foreign national but have UK property or assets, you'll be liable for UK Inheritance Tax if the value of those assets come to more than the £325,000 limit.

Tax treatment depends on the individual circumstances and may be subject to change in future.

What is the Inheritance Tax nil-rate band?

With lots of rules, exceptions and reliefs, Inheritance Tax can get quite complicated. Understanding the nil-rate band is key to it all.

The nil rate band is, in effect, a personal IHT tax allowance. Every person who is subject to potential IHT has their own £325,000 allowance, and you'll only become liable for Inheritance Tax if your estate exceeds that amount.

This allowance can be increased in certain circumstances too. For example, if you were to leave your main residence to a direct descendant when you die, an additional 'residence nil-rate band' will be added.

Until 2030, the maximum residence nil rate band is frozen at £175,000. This gets added to your existing nil-rate band of £325,000 - so your estate could be worth up to £500,000 before any IHT is payable.

For example, let's say you leave behind savings, investments and possessions worth £110,000, and your main residence  worth £340,000. The total value of your estate is £450,000, which would ordinarily exceed the nil-rate band. However, if you leave the property to a direct descendant, the residence nil rate band extends your allowance to £500,000 (£325,000 + £175,000).

Not only does this mean no Inheritance Tax would be due, but it also means £50,000 of your nil rate band would go unused. This unused proportion of your allowance can be transferred to the estate of your surviving spouse, thus increasing their nil rate band for the future.

Note that if you co-own your property, only the value of your share will be counted among your estate. In the case above, if you had a 50% share in the house, it would be worth £170,000 – so even combined with your savings and possessions, you'd be within the nil-rate band regardless of who you left your estate to.

How to value an estate for Inheritance Tax

When valuing your estate for Inheritance Tax purposes, you firstly need to make an estimate of its total value so you can work out whether it's liable for IHT or not. If the estimate exceeds the £325,000 threshold, then a more accurate valuation will be needed.

A valuation should include:

• Everything you own. This is classed as your assets and may include property, land, savings, investments, money etc.
• Assets held in trust ('relevant property') for which you are the beneficiary.
• Any gifts you have made in the past seven years, such as cash, valuables, contributions to a Junior ISA.
• Any assets you hold abroad.

Adding these together will give you a total. From this total you can deduct any debts, such as outstanding mortgages, loans etc. This gives you the value of your estate, indicating the amount of Inheritance Tax that may be owed after your death.

How much is Inheritance Tax?

Given the rapid rise in house prices over recent decades, more and more people find their estates exceeding the IHT threshold even with the benefits of the residence nil-rate band.

In the table below, you can see how much Inheritance Tax might be payable on your estate, whether you're able to claim the full £175,000 relief against the value of your home or not.

Note, this doesn't consider any extra allowance you may be able to claim following the death of a partner.

Who pays Inheritance Tax?

Everybody in the UK whose estate exceeds the £325,000 threshold is potentially liable for Inheritance Tax when they die. In cases where there's a will, it's the duty of the executor to arrange this payment. Where there's no will, the administrator of the estate performs this role.

A popular misconception is that it's the beneficiaries who pay IHT, whereas it's actually paid before they can receive anything. The exception to this rule is where lifetime gifts are concerned. In such cases, it's the beneficiary of the gift who pays.

When do you pay Inheritance Tax?

Inheritance Tax must be paid within six months of your dying, with interest charged on late payments. There is the possibility for payment by instalments on certain assets, such as property, that may need to be sold to cover the amount due.

It must also be paid before any beneficiaries of your estate can receive the assets left to them. This is to ensure the funds are available to pay the correct amount of IHT.

Inheritance Tax for married couples

Being married or in a civil partnership can bring some major benefits when it comes to IHT.

If your will passes all your assets to your wife, husband or registered civil partner, then there won't normally be any IHT to pay. What's more, your nil-rate band won't be used at all – so your surviving partner can effectively double theirs.

It's up to the legal personal representatives of the second spouse or civil partner to claim the transfer of the unused nil-rate band when the second partner dies. Doing so can reduce the Inheritance Tax that's due on assets passed down to your children, or other family and friends.

Here's a quick example of how it works

Mr Smith died in 2018, leaving his estate to his wife. As the assets passed to his spouse, none of Mr Smith's nil-rate band was used. Mrs Smith then passes away in 2020, with a total estate worth £600,000 left to nieces and nephews.

As none of Mr Smith's nil-rate band was used, 100% of it (£325,000) can be added to Mrs Smith's own nil-rate band (also £325,000), increasing Mrs Smith's nil rate band to £650,000.

As a result, no IHT needs to be paid.

If Mr Smith's nil-rate band hadn't been transferred, then £110,000 IHT would have to be paid. This is 40% of £275,000, the value of Mrs Smith's estate (£600,000) less her own nil rate band (£325,000).

Inheritance Tax on gifts

Giving money or assets to your beneficiaries while you're still alive is one of the most common strategies to reduce Inheritance Tax. However, there are rules around what you can give, and when you can give it.

Indeed, when the value of your estate is calculated, it will include the total value of certain gifts you made in the seven years before your death, or at any time if you continued to benefit from the gifted property thereafter (these are known as 'gifts with reservation of benefit').

Lifetime gifts generally fall into one of the following three categories:

Exempt transfers

Exempt transfers are gifts you can legitimately make at any time, without incurring any Inheritance Tax. These include:

• Gifts of any value between spouses or registered civil partners
• Annual gifts of up to £3,000 in each tax year
• Regular payments out of your income. Regular payments paid directly out of your income can help stop the value of your estate increasing. There's no set limit on these payments, but they will only qualify for exemption if you have enough income left to fund your normal lifestyle
• Wedding gifts or civil partnership ceremony gifts (you can give £5,000 to your children, £2,500 to grandchildren or £1,000 to anyone else)
• Small gifts of up to £250 per person, per year
• Gifts to charities, political parties or national organisations (donations are tax-free during your lifetime, and when you leave money to charity in your will)

Potentially exempt transfers (PETs)

Potentially exempt transfers (PETs) are gifts to individuals (as well as gifts into certain specific types of trusts) which exceed the available exemptions above.

There is no Inheritance Tax to pay straight away when you make the transfer, but IHT will need to be paid if you die within seven years and the value of the PET puts you over the nil rate band.

Gifts made less than three years before your death incur the full 40% tax charge. Gifts made three to seven years before you die are taxed on a sliding scale known as taper relief.

For example, if you make a PET of £100,000 but die within three years with an estate value of £300,000, the PET is added to the value of your estate to make £400,000. There'll therefore be an IHT bill of £30,000 (40% of the £75,000 over the nil rate band).

Assuming you live for more than seven years following the PET, its value wouldn't be added to your estate when you die. In this case, there would be no Inheritance Tax to pay on the gift.

Chargeable lifetime transfers

A transfer is classed as a chargeable lifetime transfer (CLT) when an individual makes a gift that is not outright, for example, a gift into a flexible or discretionary trust.

There will be no Inheritance Tax to pay when making a CLT, if your total amount of CLTs in the previous seven years is less than the available nil rate band.

If the CLT, when added to the total amount of CLTs in the previous seven years exceeds the nil rate band, there will be a lifetime Inheritance Tax charge of 20% on the excess amount.

Chargeable lifetime transfers will usually fall outside of your estate for IHT purposes if you survive for at least seven years after the CLT was made. However, if you die within seven years of making the CLT, then its value will be part of your estate.

Any Inheritance Tax you already paid on a CLT when you were alive will be deducted from any IHT due on it after your death.

Things to consider before making lifetime gifts

Lifetime gifts are often seen as a simple way to reduce Inheritance Tax, but as you can see above, it's a complicated matter that needs serious thought.

As well as ensuring you abide by the rules, you'll need to consider the affordability of giving gifts, without leaving yourself short in your later years – when you may need to pay for things like care.

You'll also need to think about when you want your beneficiaries to gain access to the assets you gift them. For instance, you may want to give money to your children or grandchildren but retain control over what age they receive it. This can sometimes be done by placing the money into trust.

If you're looking at ways to manage your estate value, it might be a good idea to speak to a Specialist Financial Adviser from Wesleyan Financial Services.

Please bear in mind that advice in relation to Inheritance Tax planning is not regulated by the Financial Conduct Authority.

Who pays Inheritance Tax on gifts?

Gifts that fit the criteria for Inheritance Tax are considered first when it comes to the IHT threshold. If their value exceeds this allowance, then it's the beneficiaries of these gifts that are liable for paying the 40% due on the excess, regardless of whether the gift has been spent or sold.

Probate and Inheritance Tax

Generally, probate is a term used for the business of dealing with the deceased's estate. That includes all the financial and legal processes related to such a task.

On a more technical level, probate is a legal document that must be applied for, giving a named executor the authority to distribute assets in accordance with a will.

Probate can't be granted until the estate has been fully valued and at least some of the Inheritance Tax has been paid.

Trusts and Inheritance Tax

A trust is a legal arrangement you can create where your asset (or your gift) is held by a trustee or group of trustees, for the ultimate benefit of a named third party (your beneficiary).

When the investment is transferred to the trustees, it no longer technically belongs to you – so it won't be counted as part of your estate when you die (subject to all the other rules above). This can significantly reduce Inheritance Tax liability for the people you're passing the assets to.

What's more, if you gift money into a trust, you can control how and when the money is paid out. It's a way of making sure your plan is dealt with in line with your wishes when you die.

Just bear in mind that you may lose access to the money yourself once it goes into trust. That's why you should always discuss things with an expert before making any big decisions.

Find out more about trusts and how they work in our comprehensive guide to trusts.

Equity release and Inheritance Tax

Equity release is the term for financial products that allow you to release the money tied up in your home and take it as tax-free payments. This can have the effect of reducing the value of your estate. You can read more about whether equity release can reduce Inheritance Tax here.

Inheritance Tax reliefs

Even though Inheritance Tax is payable on the total value of your estate, relief is available on certain assets. The types of relief available are:

• Business relief – Can be claimed to reduce the value of a business or its assets for the purposes of Inheritance Tax
• Agricultural relief – Can be claimed on the transfer of agricultural property to reduce the amount of IHT payable

It might be useful to get financial advice to find out whether either of these reliefs would apply to your estate.

Using life insurance to pay Inheritance Tax

It's possible to provide for some, or all of any Inheritance Tax bill, via a life insurance policy.

It would need to be a whole-of-life insurance policy, which pays out on your death, as opposed to term insurance, which provides cover over an agreed period. The life insurance policy would also need to be set up in trust.

The reason for setting it up in trust is so that the payout isn't considered part of your estate and itself liable for IHT.

It's worth noting that this doesn't take into account the 10-year anniversary charge, where Inheritance Tax is payable every 10 years after a trust is set up. But if the policy is intended to settle any IHT obligations, the 10-year anniversary charge would be irrelevant.

As long as you keep up the premiums on the whole-of-life insurance policy, and there's enough there to cover the amount owed, the beneficiaries won't lose out on what you leave to them.