Most people think that inheritance tax only applies to the very wealthy, but with the average house price ranging from £250,000 in the UK, to £485,000 in London, the size of an estate can soon approach the inheritance tax threshold.
What is Inheritance Tax?Inheritance tax is a tax paid to the government on assets over a certain amount. The tax amount is 40% on assets over the allowance. Assets that are taken into account include property, land, jewellery, possessions, money and life insurance that is not in trust. This includes jointly owned assets. Any liabilities such as mortgages, credit cards and loans would be deducted from the assets to calculate the value of the ‘estate’.Any gifts (above the gift allowance) made within 7 years of death would also be included within the assets of the estate.
What is the threshold?The current standard allowance for inheritance tax is £325,000. There is an additional residence allowance of £150,000 (which rises to £175,000 in 2020-21). There is a caveat on the additional residence allowance in that it only applies if the family home is left to a direct linear descendent. This means a child, grandchild or great grandchild etc.A couple would have an allowance of £950,000 if they were leaving a property to a direct linear descendent. If they were not leaving a property to a direct linear descendant then their allowance would be £650,000.Similarly a single person leaving a property to a direct linear descendent would have an allowance of £475,000 and if they were not leaving a property to a direct linear descendent then their allowance would be £325,000.
How can I pay less?
- Spend it! If you spend your money on yourself and don’t buy assets then it will keep it out of the hands of the taxman. This could involve going on holidays for example.
- Give it away! You have annual allowances for gifts so make the most of them! You can gift £3,000 year and if you haven’t made any gifts in the previous year then you could gift £6000 by carrying over the previous year’s allowance.You can make gifts on marriage, for example a parent can make a gift of £5,000 to a child. If there are 2 parents then this means a total of £10,000. There are different allowances if you are a different relative or no relation.You can give unlimited gifts of £250 year. So if you have 10 grandchildren you could, for example, give them all £250 and know that the gift wouldn’t be counted for inheritance tax even if you were to die within 7 years. You need to be careful as you wouldn’t be able to add the £250 to a gift of £3,000 already given.If you decide to gift money or assets absolutely to family above these amounts then as long as you live for 7 years it will generally be free of inheritance tax. If you are in poor health with a low life expectancy then gifting assets may not be a successful strategy. However be aware that the gift is now owned by the family member and on divorce the asset may be caught up in the divorce proceedings. In order to maintain more control over this potential issue putting the asset into a trust would give more control however an individual cannot gift more than £325,000 within a 7 year period without being subject to a ‘lifetime IHT’ charge of 20% Gift out of surplus income – If you have surplus income and you are not going to affect your standard of living and lifestyle then you can give regular gifts out of income. This could involve paying for school fees for a grandchild or helping out a child. Because the money is taken out of your income it is not classed as reducing the value of your estate so there is no inheritance tax payable.Gift assets while you are alive and in good health – this could include money, property, shares and other assets. If you know you are £100,000 over the inheritance tax threshold then your estate would have a tax liability of £40,000 on death. If you gift £100,000 of assets then there would be no liability on death, as long as you survived 7 years after making the gift.
- Give money to charity – Not only does this reduce the value of your estate on death but if you leave at least 10% to charity then it reduces your estates liability from 40% down to 36%.
- Current and new life insurance – Put a whole of life insurance policy in place – this is a policy that is designed to pay out on death. If you were single and had a house worth £500,000 and no other assets and wanted to leave this to you son or daughter then, assuming you haven’t made any gifts above the allowance in the last 7 years, you would be £25,000 over the allowance (standard allowance of £325,000 plus residence allowance of £150,000). This would mean that 40% tax of £25,000 was due on death which is £10,000. If your son / daughter wants to remain in the house and not sell it then they have to find £10,000 to pay the tax bill. The alternative is to put in place a whole of life insurance policy (written into trust for the benefit of your son / daughter) for £10,000 that would pay out on your death. Ensure life insurance policies are written in trust – If they aren’t then they fall within your estate on death and are counted towards your assets. You can name the person or persons who you want to benefit if you set up a trust.
- Get married to your partner……This may not be a popular option and possibly not the most romantic reason to get married but it may save you a fortune. In the UK there is something called a ‘spousal exemption’ and this means that you can leave all of your assets to your spouse without any immediate inheritance tax due. Let’s say we have 2 partners that live together and are not married and have no children. They jointly own a home worth £400,000 and one partner owns a rental property worth £200,000 with no mortgages and this provides an income which is relied upon. The partner with the rental property dies. The partner who dies has a standard allowance of £325,000. Their assets on death were half of the residential house (£200,000) plus the rental property (£200,000) so the total assets are £400,000. Because there is no spousal exemption the tax bill is 40% of £75,000 which is £30,000. The living partner will likely have to sell the rental property to raise funds. If they had been married then there would have been no tax due until the second death where the allowance would have been £650,000 (£325,000 + £325,000). As the joint assets are below this amount there would be no liability to tax (in todays rules).
- Pensions – money within a pension pot sits outside of your estate. Depending on the type of pension you have, it may be more tax efficient to take income from other sources to reduce the size of your estate below the inheritance tax allowance. This may then enable you to preserve your pension pot to be passed on through the generations without being subject to inheritance tax.
- Tax efficient investments – assets in the form of certain investments can be exempt from Inheritance tax. They can often be higher risk investments and must be held for a minimum of 2 years to qualify.