How the inheritance tax works and what families SHOULD know

Most estates are not affected by inheritance tax, but it still manages to be regularly considered Britain’s most hated tax.

40 per cent is charged on assets above the inheritance tax threshold when people die and has long been the subject of criticism, including a damning report by the Office of Tax Simplification.

Disgust over the inheritance tax and its quirks lies behind constant rumors that it will be radically overhauled. And chancellor Rachel Reeves is reportedly considering including inheritance tax in the budget on October 30.

Below we look at how inheritance tax works, so you can determine whether your family will have to pay it and explain why it is so unpopular.

What you need to know about inheritance tax

The inheritance tax is widely detested by the public. It is a tax on death, property, and the natural desire to pass on wealth from generation to generation.

If this irritates you, there are two very important things to keep in mind about inheritance tax.

First, only the richest 4 percent of families pay for it. Second, if this applies to you, there are many ways to plan ahead and help your loved ones avoid the tax.

That said, the 40 percent inheritance rate is drastically high if enough assets have been accumulated to make your beneficiaries responsible for a portion of them.

And the trends are going in the wrong direction for wealthy taxpayers, especially those who own a home in a high-priced area.

The property boom of recent decades and frozen thresholds are dragging many more bereaved families into the inheritance tax net and the Treasury is collecting ever-larger sums as a result.

So how much is inheritance tax and what are the best ways to protect your family from paying it?

How much is inheritance tax and who pays it?

It must be worth £325,000 if you are single, or £650,000 jointly if you are married or in a civil partnership, for your loved ones to have to pay death tax.

But there is another important allowance which increases the threshold to a joint £1m if you have a partner, own property and intend to leave money to your direct descendants.

Once an estate reaches £2 million, this home ownership allowance begins to be phased out by £1 for every £2 above this threshold. Completely disappears at £2.3 million

If you are worth more than this, your beneficiaries will have to give the government 40 percent of your assets above those levels.

People who inherit properties in areas with higher house prices, often due to work or family ties rather than choice, are generally forced to pay the largest sums.

“Typically, a 40 per cent tax is applied to a deceased person’s assets worth more than £325,000, called the nil rate band,” explains This is Money tax columnist Heather Rogers. .

‘Many people can leave assets worth an extra £175,000 without having to pay inheritance tax, if their house forms part of their estate and they leave it to their direct descendants.

‘This additional sum is what is called the nil residence rate band, and is available to claim in the event of death from 6 April 2017.

‘That means children, including those adopted, stepchildren or foster children, and the lineal descendants of those children.

‘Both protected amounts or “bands”, amounting to £500,000 per person, can be transferred to a surviving spouse or common-law partner if not used following the death of the first spouse.’

Under the last Conservative government, the thresholds explained above were frozen until April 2028, so more people’s estates have become subject to inheritance tax.

One option open to new chancellor Rachel Reeves is to merge the two bands but cut the total amount that can leave loved ones free of inheritance tax.

When do you have to pay?

Your beneficiaries will have to pay inheritance tax at the end of the sixth month after your death.

And the tax must be paid before the executors of your estate are granted probate, allowing them to access and control your funds.

Rogers explains here how to find the money to pay the inheritance tax in advance or pay it in installments, although you will be charged interest.

The usual solutions are a specialized loan or an insurance policy taken out in advance.

How do you avoid inheritance tax?

Fortunately, there are many legal ways to avoid the dreaded 40 percent “death tax” if you want to spend the maximum amount possible and are prepared to plan for the future.

But you shouldn’t lose sleep, much less start working on elaborate tactics to avoid it, unless you’re sure you’re rich enough for this to become a problem for your family.

Meanwhile, financial advisors repeatedly remind people that the most cost-effective ways to avoid inheritance tax are to spend and enjoy your wealth or give it away early.

Below is a summary of ways to do this that any ordinary person can easily do, or read our ‘Ten Tips to Legally Avoid Inheritance Tax’ for a complete guide.

Gifts: You can donate £3,000 a year, plus make unlimited small gifts of £250, free of inheritance tax.

Wedding gifts are also exempt, although the amount depends on how close you are to the bride or groom. Limits are up to £5,000 for a child, £2,500 for a grandchild or great-grandchild and £1,000 for anyone else.

You can give unlimited sums to other people if you wish, but they will be subject to the so-called seven-year rule.

Officially, they are called “potentially exempt transfer” gifts, because if you survive seven years, the money is automatically free of inheritance tax.

If you die before the seven years are up, inheritance tax is applied on a sliding scale, starting with the maximum of 40 per cent if it is within the first three years.

Surplus income: You can also contribute to someone else’s living costs (younger or older relatives, for example), but only if you can prove it comes from additional income.

Such gifts must be made from surplus funds, meaning your beneficiaries may need to show HMRC your old bank statements to prove you didn’t need to spend the money on anything else.

Pension funds: You can pass on your retirement savings to your loved ones.

Beneficiaries currently pay no tax on inherited pensions up to the limit of the deceased’s lifetime allowance if the owner dies before age 75, or their normal income tax rate if they are age 75 or older.

Supporting a cause: You can donate or bequeath money to charities and political parties and it will be excluded from your estate when inheritance tax is calculated.

A political party must have had at least one MP elected to parliament to qualify for this exemption.

There is also a way to reduce your heirs’ inheritance tax rate from 40 percent to 36 percent of your taxable estate by donating to charity, although not to a political party.

You can do this by bequeathing at least 10 percent of your net worth (the portion subject to inheritance tax) to charities in your will.