Working in Wills & Trusts law, we see a lot of misinformation surrounding inheritance tax (IHT), and we often meet clients who are under misconceptions about how best to mitigate IHT. The aim of this article is to dispel some of those myths and to clarify some common misgivings about IHT.

The Starting Point – Who pays Inheritance Tax?

One of the largest misconceptions is that everybody is liable to pay inheritance tax on their death. Around 48% of individuals believe that IHT will be payable when they die, when in reality it is only around 4% of deaths which result in the payment of IHT, according to recent statistics

The starting point is that every person in the UK has a tax-free allowance of £325k, known as the Nil Rate Band, which is taxed at 0%. Additionally, if you are passing residential property to a lineal descendant (children, stepchildren or grandchildren), then you will have a further tax-free allowance of £175k, which is also taxed at 0%. This allowance is known as the Residence Nil Rate Band. For an unmarried person, this means there is a maximum tax-free allowance of £500k.

For married couples, any assets passing between spouses are completely exempt from inheritance tax. In addition, any unused Nil Rate Band (£325k) and Residence Nil Rate Band (£175k for residential property, subject to certain conditions) can be transferred between spouses too. This means that married couples have a maximum tax-free allowance of £1 million.

For example, take a married couple with around £1m of assets, including the family home worth £400k. The couple intend to pass their entire estate to the surviving spouse on first death and then everything, including the family home, to their children on second death. They will have no inheritance tax to pay on first death because everything passing between spouses is exempt. On the second death, their estate will benefit from two tax-free allowances of £325k, plus another two allowances of £175k for the residential property. This will give them a total of £1 million which is taxed at 0%, and anything above £1 million is subject to IHT at 40%.

Does having a Will in place impact IHT?

In most scenarios, having a Will in place will not change your inheritance tax position. However, an important exception to this is for people who are married with children.

If you die without having a valid Will in place, your estate passes via the rules of intestacy. Most people assume that when a married person dies, everything passes to the surviving spouse, but that is not necessarily the case. Under the rules of intestacy, the first £322k of the estate passes to the surviving spouse and anything remaining is split equally between the surviving spouse and the children.

Anything which passes to the surviving spouse is exempt from inheritance tax but the assets passing to the children are taxable at 40% (subject to relevant tax-free allowances). Depending on the size of the estate, this could necessitate the sale of non-liquid assets, such as the family home, in order to pay the tax bill.

To prevent this situation from occurring, we recommend that everyone who owns a property should put a Will in place, particularly those who are married and have children.

Gifting Assets – An Effective IHT Planning Strategy?

Giving assets away before you die is an effective way of mitigating inheritance tax, but there are 2 important caveats to this.

The first is timing. Any assets which are given away within 7 years before death are included in the inheritance tax calculation on death. It is, therefore, not as simple as giving away your entire estate immediately before your death.  

The second caveat is that the asset must actually be given away. If you give an asset away but you continue to benefit from it, then the value of that asset will still be included in your estate for IHT purposes. For example, transferring your house into your children’s names is not effective for inheritance tax purposes if you are still living in the property because you are still retaining a benefit by residing there.

What about putting Assets into Trust

Transferring assets into a Trust structure can be an effective IHT planning strategy. However, be wary that Trusts themselves are still subject to inheritance tax. The taxation of Trusts is a complex area, but the general point is that assets in a discretionary Trust are taxed at 6% every 10 years, which is preferable to a tax charge of 40% on death.

The caveat to this is that an individual can only place £325k of assets into a Trust without an immediate charge to IHT. Anything above £325k is subject to an immediate inheritance tax charge of 20%. In addition to this, if you die within 7 years of putting the asset into Trust, that charge is bumped up to the full IHT rate of 40%.

As with gifting assets to individuals, you also need to ensure that you are actually giving away the relevant assets. This means that you cannot be a beneficiary of the Trust or continue to derive a benefit from the assets in the Trust, otherwise the Trust assets will also form part of your taxable estate when you die.