What is the Limit for Inheritance Tax?

Inheritance tax threshold frozen until 2026 – but why is IHT planning still important? - Company News - Wollens

Inheritance tax (IHT) is one of the most important considerations when it comes to managing an estate. In countries like the United Kingdom, the U.S., and other parts of the world, it’s a tax levied on the estate (which can include property, money, and possessions) of someone who has died. Understanding the limits and rules surrounding inheritance tax is crucial for those involved in estate planning or dealing with an inheritance.

In this blog, we’ll delve into what inheritance tax is, its purpose, how it’s calculated, and most importantly, the limit for inheritance tax, particularly in the UK. We'll also explore strategies for reducing the impact of this tax on the inheritance you plan to leave behind.

1. Understanding Inheritance Tax

Inheritance tax is a tax paid by the beneficiaries of an estate or by the estate itself before the assets are distributed to the heirs. In the UK, IHT is a crucial aspect of estate planning and is considered in determining how much an heir will receive after taxes are deducted from the estate’s total value.

a) Who Pays Inheritance Tax?

Usually, the executor of the estate is responsible for paying inheritance tax before distributing assets to the beneficiaries. However, in certain cases, the tax might be paid by the beneficiaries themselves depending on the jurisdiction and the structure of the inheritance.

In the UK, inheritance tax primarily applies to the estate’s total value at the time of the person’s death. It is calculated based on the estate's value after exemptions and deductions are applied. The current rate of IHT in the UK is 40% on the portion of an estate that exceeds the tax-free threshold, often referred to as the "nil-rate band."

b) What is Included in the Estate?

An estate typically includes:

Property
Cash savings
Investments
Pensions (in some cases)
Personal possessions (art, jewelry, cars, etc.)

Anything that the deceased person owned or had an interest in at the time of death can be counted toward the value of the estate.

2. The Inheritance Tax Threshold (Nil-Rate Band)

The key to understanding inheritance tax lies in grasping the "nil-rate band," which is the portion of an estate that is exempt from IHT. The current nil-rate band is set at £325,000. This means that if the value of an estate falls below £325,000, no inheritance tax is due.

For estates that exceed this threshold, the 40% inheritance tax rate applies to the amount above the nil-rate band. For example, if an estate is valued at £500,000, inheritance tax will only be payable on £175,000 (the difference between £500,000 and £325,000), and the tax owed would be 40% of £175,000.

a) Transferable Nil-Rate Band

One of the most beneficial aspects of the IHT system for married couples or those in civil partnerships is the transferable nil-rate band. If a spouse or civil partner leaves everything to the other, no inheritance tax is due on the first death. Furthermore, the unused portion of their nil-rate band can be transferred to the surviving spouse or partner, effectively doubling the threshold to £650,000.

For example, if a husband passes away and leaves his entire estate to his wife, she will not pay any IHT at that time. When the wife later passes away, her estate can benefit from both her nil-rate band and the unused portion of her husband’s, potentially exempting the first £650,000 of the estate from IHT.

b) Residence Nil-Rate Band

In addition to the standard nil-rate band, the UK government introduced the residence nil-rate band (RNRB) in 2017 to help reduce the IHT burden on families passing down their main residence. This additional allowance is available when the deceased person’s home is left to direct descendants (children or grandchildren).

As of the 2023/2024 tax year, the residence nil-rate band is set at £175,000. When combined with the standard nil-rate band, this means that, in certain circumstances, up to £500,000 of an estate can be passed on tax-free. If both partners in a marriage or civil partnership use their full allowances, the total can rise to £1 million.

c) Threshold for Wealthy Estates

It’s important to note that the residence nil-rate band is gradually reduced for estates worth more than £2 million. For estates valued over this threshold, the RNRB is tapered away at a rate of £1 for every £2 that the estate exceeds £2 million. This means that estates worth £2.35 million or more will not benefit from the residence nil-rate band at all.

3. Exemptions and Reliefs

Several exemptions and reliefs can further reduce the amount of inheritance tax payable on an estate.

a) Gifts and the Seven-Year Rule

One of the most significant ways to reduce the value of an estate and avoid IHT is through gifts. Gifts given more than seven years before death are generally exempt from inheritance tax. This is known as the seven-year rule.

If you give away assets or money, and survive for seven years after making the gift, the value of the gift is not included in your estate for IHT purposes. However, if you pass away within seven years, the gift may still be subject to IHT, depending on when it was made.

There’s a taper relief system that applies to gifts made between three and seven years before death, which can reduce the amount of tax owed:

Less than 3 years before death: 40%
3 to 4 years before death: 32%
4 to 5 years before death: 24%
5 to 6 years before death: 16%
6 to 7 years before death: 8%
More than 7 years before death: 0%

b) Annual Gift Exemptions

In addition to the seven-year rule, there are annual gift exemptions that allow individuals to give away smaller amounts each year without them being subject to IHT. Each person can give away up to £3,000 per year without the gift being counted toward their estate for IHT purposes. If you didn’t use your annual allowance in the previous year, you can carry it forward to the current year, giving a total exemption of £6,000.

There are also other exemptions for specific types of gifts, such as:

Small gifts: Gifts of up to £250 to any number of individuals per year are exempt.
Wedding gifts: Parents can give up to £5,000 to their child as a wedding gift, £2,500 to grandchildren, and £1,000 to others, without incurring IHT.

c) Business Relief and Agricultural Relief

Certain businesses and agricultural properties may qualify for business relief or agricultural relief, which can reduce or eliminate the amount of IHT owed on them. Business relief can reduce the value of business assets by 50% or 100% when calculating the value of an estate for IHT purposes. Similarly, agricultural relief applies to qualifying agricultural land and property, reducing their value by 50% or 100%.

4. Strategies for Reducing Inheritance Tax

Given the potentially high costs of inheritance tax, many people seek strategies to reduce the tax burden on their estate and ensure that more of their wealth is passed on to their heirs.

a) Making Lifetime Gifts

As mentioned earlier, making gifts during your lifetime is a key strategy for reducing IHT. By giving away assets while you're still alive, you can reduce the overall value of your estate, potentially bringing it below the IHT threshold. The seven-year rule is particularly useful here, as gifts made more than seven years before death are completely exempt from IHT.

b) Setting Up Trusts

Placing assets into a trust can be an effective way to reduce IHT liability. Trusts allow you to transfer ownership of assets to trustees who hold them for the benefit of the beneficiaries. By doing this, the assets are no longer considered part of your estate for IHT purposes.

There are several types of trusts, including:

Bare trusts: Beneficiaries have an immediate and absolute right to the assets.
Discretionary trusts: Trustees have the discretion to decide how and when to distribute the assets to beneficiaries.
Interest in possession trusts: Beneficiaries have a right to the income generated by the trust assets, but not the assets themselves.

Trusts can be complex, and their tax implications vary, so it’s advisable to seek professional advice if you're considering setting up a trust as part of your estate planning.

c) Life Insurance

Another strategy is to take out a life insurance policy that covers the potential IHT liability. The proceeds from the policy can be used to pay the inheritance tax, ensuring that the beneficiaries are not burdened with the tax bill. However, for this strategy to be effective, the life insurance policy should be written in trust, so the payout is not included in the value of the estate.

d) Charitable Donations

Leaving part of your estate to charity can also reduce your IHT liability. Any portion of your estate left to a registered charity is exempt from IHT. Furthermore, if you leave 10% or more of your estate to charity, the IHT rate on the remaining estate is reduced from 40% to 36%.

5. International Considerations for Inheritance Tax

For individuals with assets or beneficiaries in different countries, the rules around inheritance tax can become more complicated. Different countries have different rules, thresholds, and rates for inheritance tax, and some countries may not have inheritance tax at all.

For example:

The United States: The U.S. has a federal estate tax rather than an inheritance tax. As of 2023, the federal estate tax exemption is $12.92 million per individual, meaning that estates below this value are exempt from estate tax.
France: Inheritance tax rates in France can be as high as 45%, depending on the relationship between the deceased and the beneficiary.

It’s important to be aware of the tax rules in all relevant jurisdictions when dealing with international estates.

6. Conclusion

Understanding the limit for inheritance tax and how to navigate the complexities of IHT is essential for effective estate planning. With the current nil-rate band set at £325,000, and additional allowances like the residence nil-rate band, many estates can pass on a significant portion of wealth tax-free. However, larger estates, or those with complex assets, may need to employ strategies like gifting, trusts, or life insurance to minimize the tax burden.

Professional advice is crucial in this area, as the rules surrounding inheritance tax are subject to change, and individual circumstances vary widely. By taking steps early to reduce the impact of IHT, you can ensure that more of your wealth is preserved for your loved ones and beneficiaries.

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