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What is inheritance tax?

What is inheritance tax?
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Inheritance tax is a really important concept to understand. It’s vital that you and your family plan for any potential tax liability well in advance. I’m going to explain everything you need to know about this morbid but crucial topic, including individual inheritance tax threshold limits and ways you can reduce your tax bill.

What is inheritance tax?

Sometimes people crudely refer to inheritance tax (IHT) as a death tax. This is because it is a tax liability that arises when you die.

By adding together all of your property, money, and possessions you can calculate the value of your estate. Anything over the inheritance tax threshold is liable for a whopping rate of tax (currently set at 40%).

The outcome of this is that your family may inherit a much smaller estate or even a hefty tax bill to pay. Not an ideal way to say goodbye!

There are many benefits of estate planning and preparing for an incoming inheritance tax bill is vital.

What is the individual inheritance tax threshold?

Officially, the name for this is a nil-rate band (NRB).

The current nil-rate band for individuals is £325,000. This means that up to £325,000 of assets can be transferred free of any inheritance tax.

This may sound like a lot of money but it’s important to remember this figure also includes property (including your home). So your house value alone may already put you close to or above the NRB.

You do receive some extra allowance when passing down your main home. This is your residence nil-rate band (RNRB). The amount depends on the size of your estate:

  • £175,000 if the value of your estate is under £2 million.
  • For estates over £2 million, the RNRB reduces by £1 for every £2 over £2 million.

When does IHT have to be paid?

The executors of the will must arrange the payment of inheritance tax from the estate.

This must be done by the end of the sixth month after someone dies. So you really don’t get a lot of time to pay before interest starts to apply.

Estate planning and handling can be complicated, so speaking with a financial advisor is recommended.

How to reduce your personal liability

Thankfully, there are a number of strategies you can use to reduce your inheritance tax bill.

With proper estate planning, there are steps you can take in advance, including:

  • Using a life insurance policy written in trust to offset the IHT bill.
  • Transferring assets to a spouse or civil partner.
  • Making use of all gift allowances (although some gifts may be subject to ‘taper relief’ if you die within seven years).
  • Donating 10% of your estate to charity. This can reduce the rate of tax on the rest of your estate to 36%.

Also, it’s worth mentioning that a surviving spouse or civil partner can claim for any unused portion of their deceased partner’s NRB or RNRB to be transferred over to them.

Pensions and inheritance tax

Pensions can be a great tool for keeping the value of your estate as low as possible. For the most part, pensions fall outside estate calculations.

If you were to die before the age of 75, your pension beneficiaries can potentially receive it tax-free. If you were to be over 75, it may still fall outside your estate but proceeds would be taxable at the income rate of the person inheriting it.

Also, if you have a self-invested personal pension (SIPP), you’re actually able to transfer any commercial property you own into this wrapper. This then puts them outside your estate.

However, there are some instances in which pension benefits may fall within the value of your estate. Claire Trott, Head of Pensions Strategy at St. James’s Place advises:

While many people are aware of strategies that can reduce their IHT liability, such as gifting, they may be less aware of how they impact some employee perks. Death-in-service benefits or pensions that are paid as a lump sum to a beneficiary after the death of the benefit holder will form part of that beneficiary’s estate – and IHT may become payable. 

Taking the right steps now can shield your loved ones from tax and help ensure your money goes where you want it to go after you die. Asset Preservation Trusts (APTs) are designed for the purpose of holding death-in-service and pension death benefits in such a way as to have the funds accessible to your beneficiaries while keeping them outside their estate for IHT purposes.

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