As the law currently stands in the UK, inheritance tax will be payable on your estate, typically at a rate of 40%, on anything over and above the threshold of £325,000. This is known as the nil-rate band. As such, if the net value of your estate falls well below this threshold, your worldly wealth can be left to your loved ones entirely tax-free.
That said, even for those of you whose net worth exceeds this amount, through the use of additional tax allowances and careful tax planning, you can still minimise the amount of inheritance tax payable so as to maximise the value of your estate.
Below we look at just some of the ways you can legally reduce your liability to inheritance tax during your lifetime.
The residence nil-rate band
In 2017, in addition to the standard nil-rate band, the Government introduced what’s known as a residence nil-rate band. For residential property owners, this means that the overall amount you are able to pass on to your loved ones tax-free has significantly increased.
Initially set at £100,000 (2017/18), this new residence relief is being gradually phased in. For 2019/20 it is set at £150,000, and is set to increase to £175,000 for the year 2020/2021. This means that by 2020, you can pass on as much as £500,000 without your estate incurring any inheritance tax liability.
Crucially, however, you will only qualify for this form of tax relief if immediately prior to your death your estate includes a “qualifying residential interest”. You do not need to be living in the property at the point you passed away, although it must be a property that at some point during your life you have used as a residence.
Further, the rules state that the qualifying property must be “closely inherited”, ie; by a direct descendant, for the estate to benefit from the new residence nil-rate band.
This means that the residential property, or a share of it, must be left to a lineal descendant, such as a child or grandchild, together with their spouses or civil partners, including their widow(er) or surviving civil partner who has not remarried or entered into a new civil partnership.
Inheritance tax allowances for married couples
For those of you who are married or in a civil partnership, by law you can pass your money, possessions and property to your spouse or partner entirely tax-free. Further, he or she is then entitled to transfer any unused allowances, including the new residence nil-rate band, to any direct descendants.
The net effect of these rules is to double the amount of money a surviving spouse or partner can leave behind tax-free on their own death. Consequently, by 2020, married couples and civil partners will be able to pass on up to £1 million tax-free where residential property forms part of their estate.
Inheritance tax rules on lifetime gifts
During your own lifetime you are legally permitted to gift a certain amount of money tax-free. In particular, you have an annual inheritance tax exemption of £3,000, allowing you to give away this amount in each and every tax year without this being added to the value of your estate after you die.
Furthermore, some gifts do not count towards this annual exemption at all, including gifts between spouses, small gifts made out of your normal income or gifts to charity.
Any gift falling outside these defined exemptions are known as “potentially exempt transfers” (PETs). In other words, these are potentially exempt from inheritance tax, but only if the gift was made more than 7 years before the date of death.
Broadly speaking, if a gift is made within 7 years of death it may still be subject to inheritance tax at a rate of 40%. For gifts made between 3-7 years, inheritance tax will be payable on a sliding scale. This is known as taper relief and can vary from between 32% to as little as 8%.
Needless to say, the longer you live having made a PET, the more likely your loved ones will avoid inheritance tax on that gift.