Inheritance Tax Planning – How Should You Prepare?
Tax is the biggest expense we all have to pay throughout our lives.
It’s so big relative to many people’s incomes, yet most don’t give it a second thought.
By far the most unexpected tax of all is inheritance tax.
The unexpected nature of death (for most cases) usually means that many aren’t prepared.
Given we also avoid talking about money culturally, planning for inheritance tax is also usually ignored.
Whether you are considering your own circumstances or those of your parents or family, this subject is important.
What is inheritance tax and why should we care?
Is inheritance tax only payable on death? Or can it be paid during one’s lifetime?
What does being married have to do with inheritance tax?
And what should we be doing today to prepare for the inevitable for some?
These are just a sample of the typical type of questions people ask when it comes to inheritance tax.
Let’s now dive in and explore this subject a little deeper.
I've worked with a tax specialist for today's guest post. Her name is Eva, and she writes a tax blog at Ipsres.
Intro to Inheritance Tax
Inheritance tax is a complex tax, which requires two ingredients to understand it:
i) Your personal circumstances, and
ii) How the current tax law applies to your personal circumstances.
In most cases, the best person to deal with the complexity of the tax will be an Inheritance tax specialist.
I will not attempt to cover all of the intricacies of Inheritance tax but rather give a general overview about:
- What Inheritance tax is,
- Who pays it and when,
- How to calculate it,
- Specifically, how to calculate the value of your estate,
- The exemptions which currently exist,
- Deadlines, and
- What to do now.
The tax law related to Inheritance tax is contained in the Inheritance Tax Act 1984.
This is where to start in order to understand the basics.
You can also find information on it on the gov.uk website.
Given it can all get too mind boggling, we’ll break it down in simple terms here.
What Is Inheritance Tax and Who Pays It
Inheritance tax is the tax, which is due when someone dies.
The tax is usually paid out of the estate of the person who has died.
A person who received a gift from the deceased could also pay inheritance tax, subject to certain conditions.
In order to get your head around inheritance tax, think of it as just another tax and not tax paid only on death.
This is because there are other ways inheritance tax is payable while the person who has made the gift is still alive.
An example is if a gift is made to a trust, for an amount above the current tax-free threshold of £325,000 (aka nil rate band).
Inheritance tax would become chargeable immediately.
Depending on who pays the tax, the values of the Inheritance tax can be different.
The deceased could also have triggered an Inheritance tax charge while still alive.
This is usually the case if he/she made a gift in their lifetime without even knowing it yet.
What Is A Gift?
A gift is defined as:
- Anything with value. E.g. money, possessions or property.
- The loss in value that comes when something is transferred. E.g. If you choose to sell your house to one of your children below market value, the difference is treated as a gift.
Gifts and The 7 Year Rule
The 7-year rule is an important rule for determining whether inheritance tax is due on a gift or not.
Where Inheritance tax is due (i.e. gifts above £325k), it is charged at 40% on any gifts you give in the 3 years before death.
For any gifts given in the 3 to 7 years before your death, they are charged on a sliding scale.
This sliding scale is called ‘Taper Relief’ and works like this:
Number of years between gift and death:
Less than 3 years (40% tax is paid)
3 to 4 years (32% tax is paid)
4 to 5 years (24% tax is paid)
5 to 6 years (16% tax is paid)
6 to 7 years (8% tax is paid)
7 or more years (0% tax is paid)
Example – If you gift your property to your child today and don’t die in the next 7 years, that property will have zero inheritance tax.
But note that once you gift something, you don’t own it anymore as it goes outside your estate.
The 7 year period for 0% inheritance tax can be reduced to 2 years via Business Property Relief.
What is Inheritance Tax Charged On?
Inheritance tax will be charged on chargeable transfers.
The principle, which is used to calculate Inheritance tax is the loss to donor principle.
I.e. where the estate is calculated both before and after the transfer to see how much the estate has lost in value.
The chargeable transfer will be one, which is not an Exempt Transfer nor a Potentially Exempt Transfer (PET).
See below for the explanations of both.
The majority of the exempt gifts are of values, which are given for a specific purpose.
Exemptions for gifts up to £3,000 per tax year (6 April to 5 April) are allowed and don’t count towards your estate.
If you haven't used up the £3,000 annual exemption in the tax year it is carried forward for one year.
It can also be used to reduce the value of your chargeable estate.
Another important point to make is that there is no Inheritance tax on gifts you make to your spouse or civil partner.
There are also other smaller types of gifts you’re allowed to give tax-free. Read more here.
Potentially Exempt Transfers (PET)
Potentially exempt transfers are transfers, which are not exempt transfers and are not chargeable transfers.
If the person who has made the gift survives for 7 years following the making of the gift, the PET will become exempt and will not attract Inheritance tax.
On the other hand, if the person who has made the gift doesn't survive for 7 years after making the gift, the transfer becomes chargeable.
Inheritance tax will be due by the person who has received the gift.
Let me include an example as it is important to see how the exemptions interact with the PET calculation.
John makes the following lifetime gifts in the tax year 2018-19:
Apr 18 – £2,000 to his son
May 18 – £50,000 to his wife
Jan 19 – £20,000 to his daughter for her wedding
It's assumed that John hasn't used his annual exemption from the previous tax year.
Inheritance tax analysis:
£2,000 to his son – this will fall under the annual exemption if this is the first transfer in the tax year. £1,000 (£,3000 exemption less £2,000) remains to be used
£50,000 to his wife – exempt as this is a gift to a spouse
Daughter's wedding gift 20,000
marriage exemption (5,000)
annual exemption 2018-19 (1,000)
annual exemption 2017-18 (3,000)
If John dies within 7 years of making the gift (Jan 2026), the PET will become chargeable and will be subject to Inheritance tax.
Chargeable Lifetime Transfers (CLT)
If the transfer is not an exempt transfer or a potential lifetime transfer, it will become chargeable lifetime transfer.
David makes a gift to a trust of £400,000 in Feb 2019.
No other gifts will be made in the tax year 2018-19.
David hasn't made any other chargeable lifetime transfers in the previous 7 years.
How to calculate the Inheritance tax due:
A gift to a trust 400,000
annual exemption 2018-19 (3,000)
annual exemption 2017 -18 (3,000)
Inheritance tax will be chargeable on the value above the nil band which currently stands at £325,000.
Nil rate band (325,000)
The Inheritance tax due will be 13,800 calculated at 20% on the 69,000 and will be payable by the trustees.
These calculations are not as straightforward as I set them out to be but should give you a good idea.
How to Calculate The Value of Your Estate
When someone dies, the amount chargeable to Inheritance tax will be the value of all of the assets of the deceased less the liabilities.
I.e. the “estate” or in simpler terms, the net worth.
The assets will represent items from which the deceased would have generated some sort of value or benefit.
An example would be a house, cash, ISA account, investments in the form of shares in a company, insurance, etc.
Liabilities could generally be considered items, which are not generating value but something owed to someone. I.e. usually incurred in order to generate an asset.
For example, the deceased will usually need to pay income tax (a liability), so a tax return will need to be completed and submitted to HMRC.
Other liabilities will be amounts due such as debt, household bills, mortgage, etc.
The way you need to value the estate is at prices, which currently exist on the market.
You will need to find the current market price of the asset, which a buyer would be willing to pay in exchange for purchasing the asset.
For professional help with valuing an estate, read this guidance from Money Advice Service.
In addition to the heartbreak that comes with someone dying, there are also the practicalities of paying inheritance tax.
These are ofcourse only payable if they are due, however, payments must be made to meet the deadline.
The requirements are that inheritance forms have to be sent within one year.
But, payments for inheritance tax are due by the end of the sixth month after someone dies.
For more on deadlines, read here.
In order to ofcourse know how much inheritance tax is due to be paid, one must first value their estate.
Inheritance Tax: Things To Do Now
With all this information, things can seem overwhelming.
The key is to not be too emotional about the inevitability of death but to start being proactive today.
Below are some tips for what to do now:
1) Start keeping a record of all of the gifts you are making including the date this is made.
Note the type of gifts, who the gifts are made to, what is the relationship you have with this person and why the gifts are made.
2) Start keeping track of all gifts made to a trust.
The creation of a trust will be a complex process on its own.
It will highly likely involve an adviser telling you what tax will be owed and when.
3) Ensure you have a list of your assets and liabilities as of the current moment.
You can keep track on a spreadsheet, which you update once or twice a year.
This will generate valuable information for anyone who has to deal with your estate.
You can, of course, do the same on behalf of a relative in order to make things a bit easier.
It goes without saying that whatever you do you will need to ensure you have people you can trust to fulfill the requirements when this day comes.
4) Communicate with these people about what you are doing and where your records are.
5) Write a will that documents who you want your assets to go to.
This is something you can do as part of your inheritance tax planning.
On a related point, if you have life insurance, contact your provider and ask them to put it in trust.
This is usually done for free, and the benefit is that any proceeds of your life insurance get excluded from your estate.
Inheritance tax is a tax you can predict and prepare for.
With the knowledge you now have, why lose you and your family’s future wealth due to lack of planning?
The key is to act today and equip yourself with as much information as possible. Don’t wait till tomorrow, tick one thing off today.
Make that call, fill that form in, take professional advice or have that conversation before it is too late.
Wills and trusts are all about planning for things you cannot fully perceive.
Just because you can’t see them yet doesn’t mean they won’t happen.
So act today and act fast! It will stop your family worrying about the bureaucracy of death.
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What are you doing to prepare for inheritance tax if it applies to you?
Do please share this post if you found it useful, and remember, in all things be thankful and Seek Joy.