Guide to inheritance tax planning (IHT)

Guide to Inheritance Tax Planning

What is inheritance tax (IHT) and how does it work?
Inheritance Tax (IT) is a tax that you pay on your estate that you pass to your beneficiaries upon death.
Contact us if you believe you are going to have an inheritance tax liability and need help.

This insight attempts to answer the following questions: -

  • What is Inheritance Tax?

  • How does inheritance tax work?

  • What is the nil rate band?

  • Do you pay inheritance tax on gifts?

  • What is an exempt transfer?

  • What is a Potentially Exempt Transfer (PET)?

  • What is a Chargeable Lifetime Transfer (CLT)?

  • What is a taper relief?

You typically pay Inheritance Tax (IT) on your estate which you pass to your beneficiaries on your death. It can also be charged on certain gifts depending on when they are gifted prior to death. Your spouse is not considered as a beneficiary and IHT does not apply.

IHT applies to people who are normally residents in the UK (UK domiciled individuals). Assets of a UK resident held outside UK are also considered for IHT purposes. Likewise, UK assets of people who live abroad are also considered for IHT purposes. So being a UK resident, if you have investments outside the UK, they are also considered for IHT purposes or if you are a foreign national having a UK property, IHT still applies.

It is important to note that IHT is not calculated on your assets, but calculated on your net estate, i.e, your assets minus liabilities.

What is the nil rate band?

The nil rate band is your individual allowance up to which no IHT applies. This is currently £325,000. So if your estate is worth £325,000 or lesser, no IHT is due. If you leave your main residence to your children (including adopted, foster, stepchildren) or grandchildren, you can increase the threshold to £500,000. In other words, you get an additional nil rate band of £175,000 (if your estate is worth less than £2 million). If you pass your entire estate to your husband, wife, registered civil partner, you will not normally have to pay IHT and your nil rate band will be unaffected. Your surviving partner will be able to add your nil rate band to theirs.

Inheritance tax on gifts

Gifting during one's lifetime is an effective way to reduce IHT liability. It largely depends on the timing of certain gifts. For IHT calculation purposes, all gifts made within 7 years of one's death are included. If you gift someone but continue to benefit from it, it is considered 'gift with reservation' and is considered part of your estate when calculating IHT.

What is an exempt transfer?

These are gifts that you make any time during your lifetime without incurring inheritance tax.

  • Gifts of any value to your spouse or registered civil partners.
  • Gifts of up to £250 a year per person
  • Gifts of up to £3,000 per tax year
  • Wedding gifts to children of up to £5,000 or £2,500 to grandchildren or £1,000 to anyone else.
  • Charitable donations

What is a potentially exempt transfer?

Potentially exempt transfers (PETs) are a way of making gifts to friends or family. It is any transfer that is not a chargeable lifetime transfer or an exempt transfer and includes gifts to: -

  • another individual
  • a trust for the disabled
  • a bare trust or absolute trust
There is no immediate tax liability at the time PET is made and no obligation to report to HMRC. However, PETs are included in the ongoing cumulation for IHT purposes. A person making a gift must survive for 7 years from making the gift, otherwise it will be considered as part of the estate and will be included for IHT calculation purposes.

What is a chargeable lifetime transfer?

Gifts into a discretionary trust are considered chargeable lifetime transfers. Such gifts together with any previous gifts, if made within 7 years prior to death exceed the nil rate band, will be subject to IHT. Chargeable Lifetime Transfers are not necessarily immediately chargeable, it depends on the settlor’s lifetime cumulation.

What is the taper relief?

You get a reduction in IHT when a gift is over the nil rate band and works when death occurs within 3 to 7 years from gifting.

  • 20% reduction when death occurs between 3 and 4 years after gifting.
  • 40% reduction when death occurs between 4 and 5 years after gifting.
  • 60% reduction when death occurs between 5 and 6 years after gifting.
  • 80% reduction when death occurs between 6 and 7 years after gifting.
Taper relief is only available when the value of gifts is above the nil rate band and when death occurs between 3 and 7 years after gifting.

For example, you gift someone £500,000 and then die 6 years later. You did not own a home and on your death, this becomes a failed Potentially Exempt Transfer (PET) and exceeds the nil rate band by £175,000. Since taper relief only applies to the tax, we calculate the tax first. This is £175,000 X 40% = £70,000. Because you survived between 6 and 7 years after gifting, a taper relief of 20% can be used and this will result in £70,000 X 20% = £14,000 of inheritance tax.

Please note tax laws could change the way Inheritance Tax Liability is calculated and taxed and your tax situation depends on your individual circumstances.