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How to Calculate Inheritance Tax

How to Calculate Inheritance Tax

When you pass away, you’ll want to do everything you can to make sure you secure your family’s financial future.

However, this can be difficult to do. The Inheritance Tax rules could mean the government is the biggest beneficiary of your estate, rather than your spouse or civil partner and direct descendants.

Individuals with estates worth many thousands of pounds could find themselves with a large tax bill if they don’t give any thought to reducing their Inheritance Tax position.

This blog will explain what Inheritance Tax is, how to calculate Inheritance Tax, and ways to mitigate a potential Inheritance Tax bill.

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What is Inheritance Tax?

Inheritance Tax, also known as IHT, is the tax charged on the value of your estate when you pass away. It applies if the value of your estate is worth more than a certain amount (see below).

When you die, your executors will calculate how much your estate is worth and pay Inheritance Tax out of it.

What is an “executor”?

An executor is an appointed representative named in a will. It’s their job to calculate the value of the deceased’s estate.

Anyone over the age of 18 can be named as an executor. They don’t necessarily need a full understanding of the Inheritance Tax rules to take on the role.

However, it can be useful to have a professional tax adviser in this position.

Who has to pay Inheritance Tax and how much will you owe?

In short, everyone may have to pay Inheritance Tax. However, the amount of Inheritance Tax you’ll pay depends on your specific circumstances, such as the total value of your estate and any tax-saving measures you’ve put in place.

The basic rate of Inheritance Tax is 40%. This means nearly half of the total value could go straight to the government, rather than to your family.

However, some parts of your estate won’t be subject to Inheritance Tax.

For example, while investments and ISAs count towards your estate, money held in pensions is typically Inheritance Tax-free.

The nil-rate band

As well as other assets that are tax-free, every person has a tax-free allowance before Inheritance Tax is due. This is known as the nil-rate band (NRB), and it’s a key Inheritance Tax threshold to be aware of.

In the 2021/22 tax year, the nil-rate band is £325,000. This amount will not be included in the value of the deceased’s estate, meaning it can be passed to their direct descendants and spouse or civil partner without being subject to Inheritance Tax.

Any part of the NRB that is not used when the first spouse or civil partner dies can be transferred to the surviving spouse or civil partner for use on their later death.

Inheritance Tax and property

There is also an additional allowance called the residence nil-rate band.

This extra allowance only comes into play if you pass your main residence to your direct descendants, such as your children or grandchildren.

Currently, the residence nil-rate band is £175,000, taking your total tax-free amount to £500,000.

The residence nil-rate band only counts on your main residence, not for other properties such as buy-to-lets or investment properties.

An example of how Inheritance Tax is calculated

Consider these two examples for how Inheritance Tax is calculated.

Example 1

In this example, assume that this is an individual who is unmarried and has no children. Their total assets are worth £750,000, consisting of:

  • Their main residence, worth £350,000, with no mortgage left to pay.
  • Savings of £150,000.
  • Investments worth £100,000.
  • A buy-to-let property worth £100,000.
  • Their other possessions, such as their car, worth £50,00o.

They have no other debts.

In this situation, they’ll be able to make use of the nil-rate band of £325,000, but not the residence nil-rate band as they have no direct descendants to pass their home to. This gives them a tax-free amount of £325,000.

Assuming that they have done no other Inheritance Tax planning, this exposes the remaining £425,000 of their estate to Inheritance Tax at 40%.

As a result, their tax bill will be £170,000.

Example 2

In this example, assume that this individual’s spouse has already died before them. They also have two children. Their total assets are worth £1.5 million, consisting of:

  • Their main residence, worth £600,000, with no mortgage left to pay. They will pass this home to their direct descendants.
  • Savings of £250,000.
  • Investments worth £235,000.
  • Buy-to-let properties worth £350,000 in total.
  • Their other possessions, such as their car, worth £65,00o.

They have no other debts.

In this situation, as their spouse has already died and had used none of their nil-rate band, this individual will inherit their spouse’s full nil-rate band, giving them a total exemption of £650,000.

Their spouse had also used none of their residence nil-rate band, giving them a further £350,000.

This gives them a total tax-free sum of £1 million.

Assuming they have done no other Inheritance Tax planning, this exposes the remaining £500,000 of their estate to Inheritance Tax at 40%.

That means their tax bill will be £200,000.

Use an Inheritance Tax calculator

To find out how much Inheritance Tax you may owe, you could use an Inheritance Tax calculator.

These will allow you to input all of your assets, automatically removing the nil-rate band. It will then give you a complete picture of how much tax you’ll owe.

Investment platform Hargreaves Lansdown and consumer group Which? both have an Inheritance Tax calculator available on their website.

Hargreaves Lansdown Inheritance Tax Calculator

Seek financial advice

Alternatively, you could employ the services of a professional financial advisor, in particular someone who is a tax specialist.

They’ll be able to calculate exactly how much Inheritance Tax you might owe.

They may also be able to make suggestions on how you could reduce any potential Inheritance Tax bill.

Methods for reducing a potential Inheritance Tax bill

As Inheritance Tax is so steep, it’s often a good idea to try and find methods to reduce the size of your Inheritance Tax bill.

There are lots of different methods for reducing the size of your estate and limiting Inheritance Tax. A financial advisor can help you find the ones that are most suited to you.

Gifting

A popular method for reducing your Inheritance Tax bill is by gifting your money. This helps put your money in the hands of those you love, while also reducing the size of your estate.

In theory, you can gift as much as you like to anyone. This doesn’t have to be to a direct descendant – it could be anyone of your choice.

However, you must outlive the gift by seven years. If you die within seven years after making a gift, the money will be subject to Inheritance Tax on a sliding scale, with the amount of tax depending on how soon you died after making the gift.

Years between gift and death Tax paid
less than 3 40%
3 to 4 32%
4 to 5 24%
5 to 6 16%
6 to 7 8%
7 or more 0%

The rules about gifting can be complex – for example, gifting a property and living there rent-free typically won’t reduce the value of your estate. It can pay to seek professional advice.

Tax-free gifting allowances

Aside from the seven years rule, you also have some tax-free allowances in each tax year that allow you to gift your money without worrying about a tax charge.

Gifting allowance

Each tax year, you have a gifting allowance where you can gift up to £3,000 without it being counted as part of your estate. If you have a spouse or spouse civil partner, you can combine your allowances and gift up to £6,000 in one tax year.

You can also make an unlimited number of smaller gifts, up to £250 each. The same person who received your £3,000 gift cannot receive one of these smaller gifts.

Wedding gifts

Weddings present a separate opportunity to make gifts, as you have a separate allowance.

Typically, you can gift up to £1,000 to each person who’s getting married.

If your child is getting married, you can typically gift them up to £5,000, while grandchildren can receive £2,500.

This method obviously depends on you having weddings to attend. But, if you do, they present a good opportunity to put your money in the hands of those you’d most like to have it.

Remember:

It’s important that you keep accurate records of Inheritance Tax gifts. Otherwise, your executors might mistakenly include them when calculating the value of your estate.

Charitable donations

Inheritance Tax Charitable Donations

You can reduce how much Inheritance Tax you owe by making a charitable donation in your will.

As well as reducing the value of your estate by the amount of the donation, if you leave at least 10% of your estate to charity in your will, you can reduce your Inheritance Tax rate from 40% to 36%.

This may not sound like a big reduction, but it could make a big difference in how much your family receives rather than how much they pay in tax. You’ll also support good causes that are important to you.

Life insurance policies in trust

If there is likely to be an Inheritance Tax bill when you die, you could take out a life insurance policy so your beneficiaries can use the proceeds to pay this bill. For this to work, you must put your life insurance in trust.

A trust is a legal structure that allows you to dictate when someone receives your money. You appoint a “trustee” to oversee and control the money. The trustee then gives it to the person of your choice, known as a “beneficiary”, at a time of your choosing.

By placing the life insurance policy in trust, the payout can be used by your beneficiaries to pay any Inheritance Tax bill,. The value of the life insurance payout won’t be included in your estate.

Make sure you take financial or tax advice before using this method, as it can be a complicated process.

Business relief

If you’re a business owner, you may be able to pass on parts of your business either 50% or 100% free from Inheritance Tax.

You can apply for Business Relief to remove 100% of Inheritance Tax on the whole of a business, an interest in a business, or shares in an unlisted company.

Alternatively, you can apply to remove 50% of Inheritance Tax on shares in a listed company, or land and machinery from a business. These must be specific business assets that were used to run the company.

You must own the business or its assets for at least two years before your death to make use of the relief.

Agricultural relief

Separate from business relief, you may be able to save on Inheritance Tax if you own agricultural property, such as farm or pasture land, in the UK, Channel Islands, Isle of Man, or the European Economic Area.

Agricultural relief allows you to pass on agricultural property entirely free from Inheritance Tax, provided that it meets certain criteria.

You must have either owned and occupied the land specifically for agricultural purposes for at least two years if you are the owner, or seven years if it’s occupied by somebody else.

The gov.uk website has further information on what qualifies for agricultural relief.

Bear in mind that you cannot make use of business relief and agricultural relief on the same business or asset.

Inheritance Tax planning

When it comes to securing your family’s financial future for when you’re no longer around, the best thing you can do for yourself is to seek professional advice from a financial advisor or a professional estate planner.

You may think your estate is as optimised and tax-efficient as possible, but it’s possible that you have a tax liability that you aren’t aware of. If you don’t take financial advice, you may not find out about it until it’s too late.

An advisor, particularly one that specialises in tax advice, can look at your entire financial situation and work out how much tax you owe.

They can then recommend and create tax-efficient structures that could help reduce the size of your estate and how much Inheritance Tax you’re currently liable for.

To find a trusted advisor, use our “find a local advisor” tool.

Need help finding an Independent Financial Advisor?

All advisors are registered with the Financial Conduct Authority

Please note:

Estate planning is not regulated by the Financial Conduct Authority (FCA).

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