How inheritance tax works – and what families MUST know

Most estates don’t get hit by inheritance tax but it still manages to be regularly dubbed Britain’s most hated tax.

It is charged at 40 per cent on assets above the inheritance tax threshold when people die and has long been the subject of criticism – including a damning report from the Office of Tax Simplification.

The dislike of inheritance tax and its quirks lies behind regular rumours that it will be radically overhauled. And Chancellor Rachel Reeves is reportedly considering a raid on inheritance tax in the Budget on 30 October.

Below we look at how inheritance tax works, so you can work out if your family will have to pay it, and explain why it is so unpopular.

What you need to know about inheritance tax

Inheritance tax is widely loathed by the public. It’s a tax on death, property and the natural desire to pass wealth down the generations.

If this riles you, there are two very important things to bear in mind about inheritance tax. 

First, only the richest 4 per cent of families pay it. Second, if that applies to you, there are many ways to plan ahead and help your loved ones avoid the levy.

That said, the 40 per cent inheritance rate is drastically high if you have amassed enough assets for your beneficiaries to be liable on some chunk of them.

And the trends are heading in very much the wrong direction for wealthy taxpayers, especially those who own a home in a price hotspot.

The property boom over recent decades plus frozen thresholds are dragging many more grieving families into the inheritance tax net, and the Treasury is raking in ever bigger sums as a result.

So how much is inheritance tax, and what are the best ways to shield your family from paying it.

How much is inheritance tax and who pays?

You need to be worth £325,000 if you are single, or £650,000 jointly if you are married or in a civil partnership, for your loved ones to have to stump up death duties.

But there is a further chunky allowance which increases the threshold to a joint £1million if you have a partner, own a property, and intend to leave money to your direct descendants.

Once an estate reaches £2million this own home allowance starts being removed by £1 for every £2 above this threshold. It vanishes completely by £2.3million

If you are worth more than this, your beneficiaries will have to hand over 40 per cent of your assets above those levels to the Government.

People inheriting property in the hottest house price spots, often due to work or family ties rather than by choice, are generally on the hook for the biggest sums.

‘Tax of 40 per cent is typically levied on a deceased person’s assets worth over and above £325,000, which is called the nil rate band,’ explains This is Money’s tax columnist, Heather Rogers.

‘Many people are allowed to leave a further £175,000 worth of assets without them becoming liable for inheritance tax, if their home forms part of their estate and they leave it to direct descendants.

‘This extra sum is what is called the residence nil rate band, and it is available to claim on deaths on or after 6 April 2017.

‘That means children, including adopted, step or fostered, and those children’s linear descendants.

‘Both protected amounts or “bands”, adding up to £500,000 per person, can be transferred to a surviving spouse or civil partner if unused on the death of the first spouse.’

Under the last Tory government, the thresholds explained above were frozen until April 2028, so more people’s estates have become liable for inheritance tax.

One option open to new Chancellor Rachel Reeves is to merge the two bands, but cut the overall amount you can leave to loved ones free of inheritance tax 

When do you have to pay?

Your beneficiaries will have to pay inheritance tax at the end of the sixth month after you die.

And the tax must be paid before the executors to your estate are granted probate, which allows them access to and control over your funds.

Rogers explains how you find the money to pay inheritance tax upfront here, or pay in instalments – though you will be charged interest. 

Common solutions are a specialist loan, or an insurance policy taken out in advance.

How do you avoid inheritance tax?

Luckily there are many legal ways to dodge the dreaded 40 per cent ‘death tax’ if you want to pass on the maximum sum possible and are prepared to plan ahead.

But you shouldn’t lose sleep – let alone start working on elaborate avoidance tactics – unless you are certain you are rich enough for it to become a problem for your family.

Meanwhile, financial advisers repeatedly remind people that the most cost effective ways to beat inheritance tax are to spend and enjoy your wealth or give it away early.

Here’s a round up of ways to do it which can be undertaken easily by any ordinary person, or read our ‘Ten tips to avoid inheritance tax legally’ for a full guide.

Gifts:  You can give £3,000 a year, plus make unlimited small gifts of £250, free from inheritance tax.

Wedding gifts are also exempt, although the amount depends on how close you are to the bride or groom. The limits are up to £5,000 to a child, £2,500 to a grandchild or great-grandchild, and £1,000 to anyone else.

You can hand unlimited sums to other people if you want, but they will fall under the so-called seven-year rule.

Officially, these are called ‘potentially exempt transfer’ gifts, because if you survive seven years the money automatically becomes free of inheritance tax.

If you die before the seven years are up, inheritance tax is levied on a sliding scale – starting at the full whack of 40 per cent if it’s within the first three years.

Surplus income: You can also contribute to the living costs of someone else – younger or older relatives, for example – but only if you can prove it’s coming out of spare income.

Such gifts must be made out of surplus funds, which means your beneficiaries may have to show HMRC your old bank statements to prove you did not need to spend that money on anything else.

Pension pots: You can pass on your retirement savings to loved ones.

At present, beneficiaries either pay no tax on inherited pensions up to the deceased’s lifetime allowance limit if the owner dies before age 75, or their normal income tax rate if they are 75 or over.

Supporting a cause: You can gift or bequeath money to charities and political parties and it will be excluded from your estate when inheritance tax is calculated.

A political party has to have succeeded in getting at least one MP elected to parliament to qualify for this exemption.

There is also a way to reduce your heirs’ inheritance tax rate from 40 per cent to 36 per cent of your taxable estate by giving to charity – although not to a political party.

You can do this by bequeathing at least 10 per cent of your net estate – the part liable for inheritance tax – to charity in your will.