HMRC recently published statistics revealing that the amount paid in inheritance tax in April and May this year is 34% higher than the amount paid in the same months last year. HMRC says that it expects this upward trend to continue. Will you be caught in the trap and what can you do to reduce the amount of tax payable when you die? The increase is in part due to the fact that the nil rate band (the amount above which inheritance tax is charged) has been frozen at £325,000 since tax year 2009/10 – and the government intends that it will remain frozen until 2020/21. Another contributing factor is the continued rise in house prices.
How does the nil rate band work?
Inheritance tax is a tax on the estate (the total value of property, money and possessions) of someone who has died. Any part of the estate that is left to a spouse or civil partner will typically be free from inheritance tax. The spouse or civil partner can also “inherit” any unused rate band. However, when their spouse or civil partner dies there could be inheritance tax to pay if the value of everything they own exceeds their total nil rate band. When someone leaves their wealth to people other than their spouse or civil partner, such as children or grandchildren, inheritance tax is payable on the amount that exceeds the nil rate band.
What about the £1m nil rate band?
If you have seen reports suggesting a £1m nil rate band per couple then you might be scratching your head. A new, additional nil rate band called the residence nil rate band is being introduced. It broadly applies when you leave your house to children and grandchildren. The allowance is being phased in over four tax years starting at £100,000 per person in 2017/18 and rising to £175,000 in 2020/21. The residence nil rate band will be gradually withdrawn for estates with a net value of more than £2 million.
How the residence nil rate band works in practice
Harry died in 2015 and left his entire estate to his wife Sally. There was no inheritance tax to pay on Harry’s death. He had not used any of his nil rate band. When Sally died in 2016, her personal representatives claimed Harry’s ‘unused’ nil rate band as well as her own, giving a combined nil rate band of £650,000. This was before the residence nil rate band was introduced. Let’s now assume that they both lived longer. Harry died in February 2016 and left everything, including his share in the family home, to his wife Sally. No inheritance tax was due on Harry’s death. In December 2020 Sally dies and leaves her entire estate to her two children. The nil rate bands available on Sally’s estate are:
Sally’s nil rate band £325,000
Harry’s unused nil rate band £325,000
Sally’s residence nil rate band £175,000
Harry’s unused residence nil rate band £175,000
If Sally had not had children or had left her estate to nieces and nephews then the residence nil rate band would not have applied to her estate.
What can you do to reduce inheritance tax?
There are a few simple ways you can reduce the value of your estate gradually, over the years. For instance, making gifts while you are alive can reduce the value of your estate. Gifts to charities, gifts up to £3,000 in a tax year and regular gifts out of income can all be immediately exempt from inheritance tax. This is useful if you have surplus income and, for instance, you make regular pension contributions on behalf of family members. You reduce the future inheritance tax bill and the recipient can enjoy a boost to their pension and tax relief. Other ‘one-off’ outright gifts are exempt, if the donor survives for seven years or more.
Removing larger amounts from the inheritance tax trap
If you need to remove larger amounts from your estate it may be appropriate to make gifts using a flexible trust where the trustees have control over who benefits and when. Another option is to take out insurance that would pay all or part of the likely tax when you eventually die. You may also be able to pass on what remains of your pension pot free of inheritance tax, if it meets various criteria. If you have investments and depending on your circumstances, you could consider moving them to investments which are exempt from inheritance tax once you have owned them for more than two years. While these can be effective strategies, whatever you do, you need to make sure that you will have enough money to live comfortably for the rest of your life.
Inheritance tax planning is a complex area and it is important to take professional financial advice before doing anything. It is also important to make sure that your Will reflects the various strategies you put in place. A professional financial adviser can recommend inheritance tax planning strategies appropriate for your circumstances and future financial needs and make sure that they are documented effectively. As usual, the sooner you start planning, the more options you are likely to have.
Tax advice which contains no investment element is not regulated by the Financial Conduct Authority.