What is inheritance tax (IHT) and how does it work?
IHT is a tax which may be paid on your estate (your money, possessions and your share of any property) when you die, reducing 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 levied on certain gifts you make while you are still alive.
IHT is currently 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 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 comes to more than the £325,000 limit.
Understanding the nil-rate band
With lots of rules, exceptions and reliefs, inheritance tax can get quite complicated – but 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 at least April 2028, 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
- 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, 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.
Inheritance tax for married couples
We’ve already seen how 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 significantly reduce the inheritance tax that’s due on assets passed down to your offspring, 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).
How much inheritance tax you might have to pay
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 take into account any extra allowance you may be able to claim following the death of a partner.
Total value of estate
|
IHT payable if full residence nil rate band of £175,000 claimed
|
IHT payable if no residence nil rate band applicable
|
---|---|---|
£325,000
|
None
|
None
|
£400,000
|
None
|
£30,000
|
£500,000
|
None
|
£70,000
|
£600,000
|
£40,000
|
£110,000
|
£800,000
|
£120,000
|
£190,000
|
£1m
|
£200,000
|
£270,000
|
Inheritance tax on gifts
Giving money or assets to your beneficiaries while you’re still alive is one of the most common strategies to pre-emptively reduce inheritance tax. However, there are a number of rules around what you can give, and when you can give it.
To find out more, take a look at our guide to IHT gifting allowances.
Using trusts to reduce 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.
Tax treatment depends on the individual circumstances and may be subject to change in future.
Please bear in mind that advice in relation to inheritance tax planning is not regulated by the Financial Conduct Authority.