It’s more important than ever to think about the tax bill you might leave behind. Inheritance tax is paid on about 5 per cent of estates, but this is expected to rise to more like 10 per cent by 2030.
It’s a controversial way for the Treasury to fill its coffers — many argue that the money has been taxed twice, and that ordinary families who were never meant to pay it have been dragged into the net.
As with most of forms of tax, there is a tangled web of allowances and exemptions to get your head around. Here’s what you need to know about who pays inheritance tax, what you pay it on and, most importantly, how much you can pass on tax-free.
What is inheritance tax?
Inheritance tax is calculated on the value of your estate — a fancy term for everything that you own, including property, savings, investments and valuables such as artwork or jewellery. From April 2027 most pensions will be included in your estate too.
Anything left to a spouse or civil partner is inheritance tax-free. The first £325,000 of your estate can also be passed on tax-free, regardless of who you give it to, thanks to what is known as the nil-rate band. There is an additional residence nil-rate band of £175,000 that applies if you are passing your main home to a direct descendant, so a child, grandchild or stepchild, or their spouse or civil partner. Adopted and fostered children also count.
You begin to lose this extra allowance if your estate is worth more than £2 million. It is reduced by £1 for every £2 above £2 million, so it is completely lost if your estate is worth more than £2.35 million.
If you do qualify for the extra allowance, you can pass on a total of £500,000 inheritance tax-free. Couples can also inherit one another’s allowances, so between them they could pass on £1 million. Anything above this is usually taxed at a rate of 40 per cent.
This means that if your estate was worth £1 million and you are leaving it to your child (and you are not married or in a civil partnership — more of that later) inheritance tax would be due on £500,000, giving a bill of £200,000 (40 per cent of £500,000). An estate worth £2.5 million, with no residence nil-rate band, would pay £870,000 inheritance tax (40 per cent of £2.175 million).
Who is exempt from inheritance tax?
Perhaps the most important thing about inheritance tax is that spouses and civil partners are completely exempt from it if they leave their estates to each other. They do not have to pay inheritance tax on anything — not even pensions when the rules change in April 2027.
The nil-rate bands are still reduced by £1 for every £2 an estate is worth above £2 million, however, with both spouses’ allowances completely lost once an estate is worth more than £2.7 million.
If you are not married or in a civil partnership and you inherit your partner’s estate you will pay inheritance tax on the value above £325,000. You would not qualify for the residence nil-rate band.
There are further exemptions too. Anything you leave to charity is tax-free, as well as any sum you leave to a community amateur sports club. If you leave 10 per cent or more of your taxable estate to a charity in your will, your other beneficiaries will pay a reduced inheritance tax rate of 36 per cent.
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Make sure to specify the charities or clubs by name in your will, ideally with their identification number, and outline the amount or proportion of the estate to be left to each one. It’s also a good idea to ensure that your family knows of these wishes.
Are gifts exempt from inheritance tax?
Unfortunately, the answer is “sometimes”.
Any gifts made seven or more years before your death will be free from inheritance tax. This is known as the seven-year rule, and in theory means that if you gave away your entire estate and then lived for seven years, your beneficiaries wouldn’t pay any tax.
For a gift to be a true gift, however, you must give up all access and benefits to the asset. For example, you cannot give away your home to your children but live there rent-free, or give away an expensive piece of artwork but still display it in your living room.
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Keep a record of what you give, when you give it and who you give it to. Make sure to include the value of the gift, and any proof that you have truly given it away. For example, if you have given away ownership of your house but pay rent to live there, keep bank statements that show the payments.
Be aware that a gift can also include any discounts you give your children. If you rent out a property to your child for £500 a month, but on the private rental market it would cost £1,000 a month, then you are seen as giving your child £500 a month.
If you die less than seven years after making a gift then its value will be included as part of your estate, and inheritance tax may be due. It’s not a seven-year cliff edge though: the rate paid on the gift decreases on a sliding scale once you have lived for three years after making it. It drops to 32 per cent after three years, 24 per cent after four years, 16 per cent after five years and 8 per cent after six years.
Taper relief only applies if the total value of gifts made in the seven years before you die is over the £325,000 inheritance tax-free threshold.
What are the inheritance tax gift allowances?
You also get yearly gift allowances, which means you can give £3,000 worth of gifts each tax year and that amount won’t be counted as part of your estate. And you can give as many gifts of up to £250 per person each tax year (as long as you have not used another allowance on the same person).
Any birthday or Christmas gifts you give from your regular income — meaning that you did not have to sell stocks and shares or take the money from savings to make the gift — are exempt.
Big occasions come with further allowances. If your child is getting married or starting a civil partnership, you can give them £5,000 and it will never be subject to inheritance tax. You can give grandchildren or great-grandchildren £2,500 and anyone else £1,000.
But most importantly, you can give as much as you like — and whenever you like — under the “normal expenditure out of income” exemption. This rule means that if your payments come from your regular monthly income, and losing that money does not reduce your standard of living, then the gifts could be exempt from inheritance tax.
There are no rules for what type of gifts count, although examples given by the government include paying rent for your child, paying into a savings account for a child under 18 and giving financial support to an elderly relative.
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There are things you can do to ensure that the taxman accepts that a gift qualifies for this exemption: give regularly (at least once a year) and write a letter of intent when you begin making the gifts.
Keep the gifts roughly the same value, and make sure that they come from income rather than capital or savings. Taking £20,000 from your savings each year as “income’ won’t count — it has to be from employment income, pension income, rental income, dividends or savings interest.
And you have to be able to prove that the money was surplus to your needs. Keep a record of everyday living costs (mortgages, insurance, bills, tax, holidays) so you can prove that your income was above and beyond what you needed to cover these costs.
If you end up having to dig into your investments to pay your tax bill because you have given away some of your income, HM Revenue & Customs is unlikely to class this gift as from surplus income.