When you've worked hard for what you've achieved in life, you want to make sure you pass your wealth on to who you choose, not the taxman.
Inheritance Tax (IHT) is a worry for many people. Paying tax is a fact of life, but IHT is one of those taxes that a surprising number of people end up paying when they don't have to. If you don't plan ahead, part of your estate could go to the taxman rather than those you want to benefit from your estate.
Under IHT rules, your estate is everything you own. This includes your home, investments and savings, and any possessions. Any debts such as a mortgage and your funeral expenses will be deducted from the value of what you own. Your estate may also include certain gifts made before death.
Everyone is currently allowed to leave up to £325,000 on death without suffering any IHT. This is known as the nil-rate band (NRB). Any excess over the NRB is taxed at 40%. Transfers between married couples or civil partners are free from IHT.
How it works
Margaret's estate is worth £600,000. She dies in the 2012-2013 tax year, so the first £325,000 of her estate is free from IHT. The remaining £275,000 is taxed at 40%, meaning an inheritance tax bill of £110,000.
For married couples and civil partners, any unused NRB from the first death can be used when the second person dies.
As an example, John dies in 2011, leaving all of his estate to his wife Mary. When Mary dies the NRB is still £325,000, but the NRB available to her estate is £650,000 (Mary's NRB of £325,000 plus 100% of the NRB as the proportion John had not used).
You can find out more about IHT allowances at www.hmrc.gov.uk.
Don't ignore IHT or leave it too late. You can plan to reduce any potential IHT liabilities, and sometimes even remove them altogether. The key is to be prepared and to act sooner rather than later.
Giving away your estate can be an effective way to reduce a future IHT liability. There are three types of lifetime gifts:
- Exempt Transfers: these are gifts where IHT will never be payable
- Potentially Exempt Transfers: these can become exempt from IHT if you survive for seven years from when you make the gift.
- Chargeable Lifetime Transfers: these may incur an immediate IHT charge of 20%. Further IHT may be payable if you die within seven years of making the gift.
To avoid making a Gift with Reservation, which will not reduce your estate for IHT, you must give the asset you are gifting away completely. If, for example, you gave your car to your son or daughter, but still use it from time to time, the taxman could class this as a Gift with Reservation and it would remain within your estate for IHT purposes.
Gifts which are Exempt Transfers are considered to be immediately outside your estate. For some gifts, the beneficiary is exempt, for example your spouse or civil partner, a charity, national institution, such as the British Museum or the National Trust, or a UK political party.
So, if you make a gift to your husband, wife or civil partner, there would generally be no inheritance tax to pay.
With other gifts, it's the type of gift that's exempt. There are several of these exemptions that you may be able to make use of. They include:
Sometimes giving money outright might not be the best solution. For instance you might want to give money to a child, but be worried about how they might spend it: or you might want to leave some money for grandchildren, but not yet know how many you'll have.
In these situations, a trust can be a good option. These can allow you to reduce the value of your estate but retain some control over who receives the gift and when.
A number of ready-made trusts schemes are available including gift plans,discounted gift plans and loan plans. How these work and their tax treatment varies so it's sensible to seek financial advice when considering these options.
If you have a large amount to give away or your situation is particularly complicated, you could have a trust tailor made for you. A solicitor will be able to do this but there will be additional costs involved.
If it is likely that IHT will be payable on your estate, a whole of life policy can be used to ensure that funds are available to pay all or some of any future IHT bill.
Provided you pay the premiums, the proceeds of the policy will be paid to your estate when you die. It is vital to have the policy written under trust to ensure that the money paid out by the policy is outside your estate. This then ensures that the money can be used to settle the IHT tax bill not add to it.
Another option is a term assurance policy (i.e., life insurance for a fixed period). If the insured person dies during the term, the payout from the policy can be used to pay off all or part of the IHT bill. With this kind of product, the life cover is provided in return for a fixed premium. At the end of the term, the cover simply ceases.
In certain situations, a lump sum may be payable from a pension plan when the member dies. Depending on the scheme rules it may be possible for the member to nominate an individual or a trust to receive this lump sum and to make this payment tax efficient.
View important information and assumptions
Laws and tax rules may change in the future. The information here is based on our understanding in September 2012. Your personal circumstances also have an impact on tax treatment. All figures relate to the 2012/13 tax year, unless otherwise stated.