Wills: Inheritance Tax Basics

what is inheritance tax?

What Is Inheritance Tax?

Inheritance tax, also known as estate tax or death duty, is a tax that is imposed on the transfer of assets after a person's death. This tax applies to the total value of an individual's estate, which includes all property, assets, and possessions. The tax rate varies depending on the size of the estate, but it can reach up to 40% in some countries.

The primary purpose of inheritance tax is to generate revenue for the government, which can then be used for public services and infrastructure projects. Some governments also use it as a way to redistribute wealth and promote social equality.

However, inheritance tax is often a subject of debate. Supporters argue that it helps to prevent the concentration of wealth and promotes economic fairness. Critics, on the other hand, contend that it can be a double taxation since the assets have likely already been taxed when they were initially acquired. Moreover, it can sometimes create financial hardship for beneficiaries who inherit property but lack liquid assets to pay the tax. To mitigate this, many countries provide certain exemptions and relief measures, such as allowing spouses to inherit tax-free or offering reduced rates for small businesses and farms. Navigating these rules can be complex, so seeking advice from a tax professional is often beneficial.

In order to work out if you have an inheritance tax liability or not, you must understand what is an estate.

Inheritance Tax Allowance

The UK Inheritance Tax Allowance is currently set at £325,000. This means that if the total value of the estate is less than £325,000, then there will be no inheritance tax payable. However, if the value of the estate is above this threshold, then the beneficiaries will be required to pay a tax of 40% on the amount above £325,000.

It's important to note that certain assets are exempt from inheritance tax, such as assets that are left to a spouse or civil partner, as well as assets that are left to a charity. In addition, the value of the family home may also be exempt under certain circumstances.

Furthermore, the UK has a unique provision known as the ‘residence nil-rate band' (RNRB), which potentially increases the inheritance tax allowance when a family home is passed on death to direct descendants like children or grandchildren. For the 2021/2022 tax year, the RNRB is £175,000. This means that if you're passing your home to your children or grandchildren, your inheritance tax threshold could be as high as £500,000 (£325,000 standard allowance + £175,000 RNRB). If you're married or in a civil partnership and your estate is worth less than your threshold, any unused threshold can be added to your partner's threshold when you die. This means their threshold can be as much as £1 million.

However, it's essential to remember that the rules around inheritance tax are complex and subject to change. There are numerous factors that can affect the amount of tax payable, including the type of assets in the estate, who the beneficiaries are, and whether any gifts were made in the seven years prior to death. As such, it's often advisable to seek professional advice when dealing with inheritance tax matters. This can help ensure that all allowances and exemptions are fully utilised, potentially saving a significant amount in taxes.

inheritance tax

Is It Possible To Avoid Inheritance Tax?

For those who are concerned about the impact of inheritance tax on their estate, there are certain strategies that can be employed to reduce the amount of tax payable. One popular strategy is to make use of the annual gifting allowance, which allows an individual to give away up to £3,000 per year without incurring any tax.

Another strategy is to use a trust. By placing assets into a trust, they are effectively removed from the estate for inheritance tax purposes. However, it's important to note that there are strict rules around trusts, and they can be complex to set up and manage.

AT ONCE Wills and Trusts we can take a look at your individual circumstances and provide a detailed review of your situation and provide bespoke strategies to reduce and in some cases completely mitigate any inheritance tax liability in the future.

Inheritance Tax Trap #1: Gifts with Reservation of Benefit (GROBs)

A gift with reservation of benefit is a legal arrangement where a person gives away an asset, such as property or money, but continues to benefit from it. The person giving away the asset is called the donor, while the one who receives it is the recipient or donee. However, the donor retains certain rights over the asset, such as the right to use it or live in it.

In practical terms, this means that the donor may continue to live in their own home even after transferring ownership to someone else. The recipient, in turn, is not allowed to use the home or benefit from it until after the donor's death.

The purpose of a gift with reservation of benefit is often to reduce the value of an estate for inheritance tax purposes, while still allowing the donor to retain the use and enjoyment of the asset. However, the rules governing such arrangements can be complex and require careful consideration.

There are several factors to consider when contemplating a gift with reservation of benefit. For example, the donor must relinquish control of the asset and the recipient must take on all the economic risks associated with it, such as maintenance costs and repairs. Additionally, such an arrangement can have an impact on any benefits the donor may be entitled to receive.

It is important to seek professional legal and financial advice before entering into a gift with reservation of benefit arrangement to ensure that all aspects are considered and that the transfer is done in a legally compliant manner.

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Inheritance Tax Trap #2: Potentially Exempt Transfers (PETs)

Potentially Exempt Transfers, commonly known as PETs, are another complex area of inheritance tax law. A PET is a gift made during a person's lifetime that will become exempt from inheritance tax if the donor survives for seven years after making the gift. The donor in this scenario is the person giving the gift, while the donee or recipient is the person receiving it.

However, if the donor dies within seven years of making the gift, the gift becomes chargeable to inheritance tax, potentially placing a significant financial burden on the recipient. This is often referred to as the ‘seven-year rule.' The rate at which tax is charged decreases on a sliding scale known as ‘taper relief' if the donor survives more than three years after making the gift.

The purpose of a PET is to enable donors to reduce the value of their estate for inheritance tax purposes over time, without having to give up the use or enjoyment of their assets immediately. However, PETs can create significant risks and uncertainties, given that they rely on the donor surviving for seven years after making the gift.

There are several factors to consider when contemplating a PET. For instance, the potential impact on the recipient if the donor does not survive the seven-year period, and the donor's health and life expectancy at the time of making the gift. Additionally, any gifts made within this seven-year period may also affect the overall inheritance tax allowance available on the donor's death.

It is crucial to seek professional advice before making a PET, to ensure that all potential risks and implications are fully understood and considered. This will help ensure that the gift is made in a legally compliant manner and that it achieves the intended tax planning objectives.

Understanding The Gifting Rules

The UK inheritance tax rules are in place to ensure that those who inherit money or assets from a deceased person pay the appropriate amount of tax. In some cases, certain exemptions may apply and there is also an additional Inheritance Tax threshold for married couples and civil partners.

The rate of Inheritance Tax depends on how much is inherited, with different rates applying depending on the value of the estate. Additionally, gifts made within seven years before death can be subject to Inheritance Tax if they exceed a certain limit. It's important to understand these rules in order to ensure that you pay the right amount of tax when inheriting property or other assets.

It's important to speak to an expert who can provide you accurate and advice and tax planning and assist you with achieving a simple solution to a complicated subject matter.

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