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Inheritance tax: How does it work and affect your giftees?

Inheritance tax of 40% is paid on what you leave to your heirs.

By LLM Reporters  |  November 7, 2021
Inheritance tax

It is never too early to consider the options when it comes to inheritance tax. Planning ahead could mean that you can pass on a significant amount to your loved ones, without such hefty tax burdens for them.

But how exactly does inheritance tax work? And what are the ways you can protect your assets for your giftees?

What is inheritance tax?

According to Close Brothers Asset Management Financial Planning Services, inheritance tax is: “A tax on the estate of someone who has passed away. Your estate consists of everything you own. This includes savings, investments, real estate, life insurance pay-outs, and personal possessions.”

The amount of tax you pay, or benefits you are entitled to, are dependent on your personal tax situation, and rules are subject to change. If investing to optimise your inheritance tax position, remember that the value of investments can fall as well as rise, and you could get back less than you invested.

Currently in the UK, there is an inheritance tax allowance threshold of £325,000. This means any amount above this threshold in your estate is charged at the standard inheritance tax rate of 40%. This threshold is also known as the nil-rate band (NRB).

To explain this further give the following example: “Your estate is worth £500,000 and your tax-free threshold is £325,000. The inheritance tax charged will be 40% of £175,000 (£500,000 minus £325,000).”

Inheritance tax is a tax on the estate (the property, money and possessions) of someone who’s died

You therefore do not have to pay inheritance tax if the value of your estate is below the £325,000 NRB. But you also do not have to pay the tax liabilities, if you leave everything above the £325,000 threshold to your spouse, civil partner, a charity or a community amateur sports club.

There are other exemptions from inheritance tax and ways that you can reduce this burden. So, let’s explore some of these further.

Inheritance tax for couples

If you are married or in a civil partnership, then there are different rules that apply to you (as mentioned above). In general, you can leave your assets to your parent, completely tax free.

If all the assets are left to the surviving partner, then they can take full advantage of both tax-free allowances. This means they have an increased inheritance tax allowance of £650,000.

Leaving assets to your grandchildren

If you are wishing to leave your home to your family in the event of your death, then this counts towards the total value of your estate, and is liable for inheritance tax.

However, if you intend to pass down your home to your children (including adopted, foster or stepchildren) or grandchildren, or if your estate is worth less than £2 million, then the inheritance tax allowance could increase to £500,000 or £1 million for a couple.

This allowance is known as the residence nil-rate band (RNRB). It works by adding an additional allowance of £175,000 per person (for the 21/22 tax year, and frozen until April 2026) for those who pass on their homes to direct descendants.

The standard inheritance tax rate is 40% of anything in your estate over the £325,000 threshold

There are some qualifying conditions in place, if you wish to make use of the RNRB, and tapering does apply to estates worth over £2 million. So, it is always best to seek expert advice from a financial professional.

Using your pension

Your pension savings could be an affective tool to pass on your wealth to your beneficiaries. This is because, in most cases, your pension can be passed on completely tax free, if you die before the age of 75.

It’s worth remembering that your pension is not covered in your will, so when planning ahead, you need to inform your pension provider who your nominated beneficiaries are.

Planning ahead

During your lifetime, there are numerous ways that you can plan for your financial future, and the future of your loved ones. One part of your plan should also be to write a will. You can appoint an executor, who becomes the person responsible for handling your estate once you pass away.

With a will, you can ensure that your assets will be distributed how you wish, and can avoid potential inheritance tax liabilities.