Key inheritance tax rules ‘worth being aware of’ to avoid tax hit

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HMRC raked in a record £6.4billion in inheritance tax receipts in the year to February 2023, which is nearly £1billion higher than the same period a year earlier. With many facing increasingly higher inheritance tax burdens as the tax-free allowance stays put at £325,000 despite soaring inflation, Britons might be wondering how to keep the potential bill as low as possible. An expert has highlighted the key rules that everyone should be aware of.

Heather Pollard, head of underwriting and inheritance expert at Tower Street Finance said: “When dealing with the short and long-term effects of bereavement, any unexpected impacts to your financial well-being can cause further stress in an already difficult and upsetting time.

“However, this has been a reality for a growing number of UK families due to a rise in HMRC investigations regarding underpaid death duties.”

HMRC issued requests for £326million in payment shortages in 2021/22 alone, which is an increase of over a quarter on the previous tax year (28 percent).

Ms Pollard continued: “One of the biggest causes of a potential inheritance tax underpayment comes from gifts made within seven years of a loved one’s death, with increasing asset values, for example, higher house values, pushing estate values above tax-free thresholds.”

Inheritance tax (IHT) is the tax that is charged on the value of an estate that was owned by someone who has passed away. The estate refers to the person’s property and valuables.

According to Ms Pollard, this includes the likes of bank accounts, pensions, homes or other buildings and land, jewellery, vehicles, shares, jointly owned assets, and pay-outs from insurance policies.

She said: “Any debts, such as mortgages, funeral expenses, other taxes or expenses are taken from the total estate value first, and then inheritance tax is only paid on the remaining amount – and only if it exceeds the inheritance tax threshold.”

Currently, the single person’s inheritance tax threshold is £325,000. So, tax is only ever paid if the value of the estate exceeds this figure, after which a 40 percent tax is applied.

Ms Pollard explained: “This means that if you inherit an estate with a value of £326,000, you’d only pay 40 percent tax on the £1,000 that is over the tax threshold. So, you’d pay £400 in inheritance tax.”

The rules are, however, slightly different for married or registered civil partners.

Ms Pollard said: “Married or registered civil partners don’t have to pay any inheritance tax on any asset (money or valuable) left by their spouse.

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“When the second partner passes away, the estate then qualifies for something called a married couple’s ‘transferable allowance’. This is essentially the inheritance tax threshold times two (for two people) and it currently stands at £650,000 – but only if none of the thresholds has been previously used.”

The person who then inherits this estate would only pay tax on anything over the value of £650,000. This extra transferable element is known as the Transferable Nil Rate Band (or TNRB).

While it may seem that inheritance tax only accounts for assets after a person passes away, there are in fact strict rules to be aware of when it comes to gifting assets while the person is still alive, too.

Inheritance tax gifting rules

Ms Pollard said: “If someone is still alive, they can gift as much money or items of value as they want, to anyone they want, in the form of something called ‘potentially exempt transfers’ (also known as PETs).”

However, she noted: “If that person passes away, those gifts (or PETs) can then be included in the total value of their estate and therefore inheritance tax may end up having to be paid.”

Under the current rules, if the gift is given before death and the donor (the person who gave the gift) lives for more than seven years after this, then no inheritance tax needs to be paid.

But if the donor dies sooner, then tax will be charged on the gifts at various levels – but only if the inheritance tax threshold is exceeded.

According to Ms Pollard, the levels include:

  • If the person dies within three years of giving the gift, a 40 percent inheritance tax is paid on anything over the threshold
  • Within three to four years – 32 percent
  • Within four to five years – 24 percent
  • Within five to six years – 16 percent
  • Within six to seven years – eight percent
  • After more than seven years – zero percent

Ms Pollard said: “Gifts use up the inheritance tax threshold before any other assets, such as property and other valuables, are calculated. They are also based on what they were worth at the time of donation, not what they were worth at the time of the donor’s death.”

Several types of gifts are exempt from inheritance tax

Ms Pollard said: “It’s worth being aware that there are several types of gifts that are exempt from IHT.”

These include:

  • Gifts to a spouse or civil partner
  • Gifts to charities
  • Multiple gifts up to £250 a year to any other person
  • Payments to help an elderly relative or minor with living costs
  • Gifts worth £3,000 or less in any tax year (excluding any £250 gifts, provided they are not to the same person)
  • Gifts made seven years or more before the donor (gift giver) passed away.

When a couple gets married, some family members are also allowed to give the following wedding gifts, and these are exempt from potential inheritance tax at any point in time too:

  • Parents can gift cash up to £5,000
  • Grandparents can gift up to £2,500 each.

Ms Pollard said: “While nobody wants to envision a time without their loved ones, a small amount of forward planning can make a real difference.

“To avoid any confusion later down the line, keep track of any gifts you have been given, who they were from, the value of the gift and when it was given. If HMRC queries any gifts, it will be up to you to provide this detail and prove the gift was given over seven years ago in order to be applicable for the zero percent tax rate.”

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