How Is Inheritance Tax Calculated & When Do you Have to Pay?

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. Firstly, only the richest 4% 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% inheritance rate is drastically high if you have amassed enough assets for your beneficiaries to be liable on some chunk of them.

How much is inheritance tax and who pays?

Estate and tax planning is a complex area, so Britons are encourgaed to always get professional advice so they can avoid common mistakes when making a gift.

Inheritance tax (IHT) is the tax that is paid on someone's estate when they pass away. All money, property and personal possessions form part of a person's estate. The value of the estate will determine whether any IHT is payable. The current rate of IHT is 40% and is only charged on the part of the estate that is above the threshold, also known as the nil-rate band. Everyone has a nil-rate band which is currently set at £325,000 until April 5, 2028.

If someone owns a property on their death, their estate can also benefit from the residence nil-rate band if ultimately the property is being left to your direct descendants, such as children or grandchildren.

The residence nil-rate band is currently £175,000. This means, someone's own personal threshold could increase to £500,000.

Exemptions
Married couples

Married couples and civil partners are allowed to pass their estate to their spouse tax-free when they die. In other words, the surviving spouse can inherit the entire estate without having to pay IHT.

They can also pass on their unused tax-free allowance to their surviving spouse or civil partner.

Annual exemption

Everyone has an annual exemption of £3,000, meaning they can give away a total of £3,000 worth of gifts each year, whether to one person or split between multiple people, without them being added to the value of the estate. They can carry an unused annual exemption forward for one tax year only.

Inheritance gift: The seven year rule

Gifts worth less than £250

People can give as many 'small gifts' up to £250 as you want each tax year, so long as they have not used another allowance on the same person.

Gifts to Charities

All gifts to UK Registered Charities are exempt from IHT.

Gifts for the maintenance of family

Any gift for the maintenance of a child who is either under 18, over 18 but in full time education or training, or is dependent upon indidivualds because they are physically or mentally disabled, will be exempt from IHT. The gift must be reasonable for the child's needs.

Lifetime exemptions
Potentially Exempt Transfers - Unlimited amounts can be given to individuals and these will be exempt provided the donor survives the gift by seven years.

Taper relief, reducing the amount of tax payable, may be available if the donor does not survive the full seven years. The donor must not "reserve a benefit".

This means that he must not continue to benefit from the item given away. If he does then he will need to pay full market rent for any occupation or use if a gift with reservation is to be avoided.

Reliefs
These may reduce the value of the gift/transfer for IHT purposes by either 50% or 100% - 100% relief effectively makes the assets exempt from IHT.

Business Property Relief

Most shares in private trading companies, or interests in unincorporated businesses as either a sole proprietor, or as a partner, will receive 100% business property relief ("BPR") and so, in effect, be exempt from IHT.

If assets are used in the business but owned outside the business by a proprietor or shareholder, or by a trust in which he is a life tenant, then 50% BPR will usually be available.

Agricultural Property Relief

Agricultural land, together with farm houses, cottages and other farm buildings of "a character appropriate" to the agricultural land may receive Agricultural Property Relief ("APR") either at 100%, and so, in effect be exempt from IHT, or at 50%.

There are complex rules associated with both of these reliefs, however, so it is essential that you take advice early to ensure that you qualify.

Inheritance Tax is a tax on the estate (property, money and possessions) of someone who's died.

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.

There's usually no Inheritance Tax to pay if either:

• The value of your estate is below the £325,000 threshold you leave everything above the £325,000 threshold to your spouse, civil partner, a charity or a community amateur sports club
• The standard Inheritance Tax rate is 40%. It's only charged on the part of your estate that's above the threshold.

For example:

Your estate is worth £500,000 and your tax-free threshold is £325,000. The Inheritance Tax charged will be 40% of £175,000 (£500,000 minus £325,000).

Who pays Inheritance Tax?

• Funds from an estate are used to pay Inheritance Tax to HM Revenue and Customs (HMRC). This is done by the person dealing with the estate (called the 'executor', if there's a will)
• Beneficiaries generally don't pay tax on things they inherit. They may have related taxes to pay, for example, if they get rental income from a house left to them in a will.

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.

8 inheritance tax traps that could cost your family a fortune

As inheritance tax receipts hit a record £7.1billion a year, a growing number of families are looking for ways to slash their costs.

From making gifts during your lifetime to setting up trusts, there are many legitimate ways to pass down money to loved ones without incurring tax. But before you steamroll ahead it is worth doing your homework.

Fail to abide by the strict rules and you could inadvertently land your family with an unexpected tax bill.

1.  Hand over home and stay in annexe – £115,000 hit
Parents often want to pass on the family home to their children – but without landing them with a massive tax bill.
A property worth up to £1million can be handed by a couple to direct descendants tax-free – but anything above this is charged at 40 per cent.

A single person with children can pass on a home worth half that sum tax free. Therefore it can be tempting for parents to hand over a family home during their lifetime, in the hope that it won’t form part of their estate for inheritance tax purposes.

There is no inheritance tax to pay on gifts so long as you live for a further seven years after making them. However, this plan can easily backfire if done incorrectly. That is because if you continue to live in the home after gifting it, it is considered a ‘gift with reservation of benefit’.

That means that the property is not deemed a genuine gift because it comes with strings attached. Should this happen, the property may still be considered part of your estate when you die and therefore could attract inheritance tax.

Ian Dyall, estate planning specialist at wealth manager Evelyn Partners, says "generally, gifts will only be effective in mitigating inheritance tax if there is no continued use of the gifted assets and no strings attached, saying that they can be returned to the donor."

The impact of this will depend on what the property is worth and what other assets you have. If, for example, you gifted your child a second home, but still used it regularly for holidays, your family could be hit with a bill of about £115,000. This assumes that you own your own home & that it is worth  more than £325,000 – or £650,000 if you’re a couple – and have a second home worth the average UK house price of £288,000. To mitigate the risk, you could pay your child rent if you plan to continue using the property.

But be careful: you must pay rent at the going market rate for it to be valid. And your children would have to pay income tax on the rent you paid them.

2.  Sell up and buy home together - £27,000 hit
Don't think you can get around the rules by selling your home and gifting your children the cash to buy another one.

Dyall says he often sees cases where parents sell their home so their child can buy a bigger property for them to all live in together. However, because the children then allow the parents to live rent-free, they risk a shock tax bill. "In some cases it is done completely innocently, perhaps by families  buying a new home together so the grown-up children can provide care for an infirm parent."

Families who do this risk falling foul of either ‘reservation of benefit’ rules, which would lead to an inheritance tax bill, or so-called ‘pre-owned asset’ legislation, which would lead to an income tax bill.

The latter would mean you could be landed with an income tax bill based on the rental value of the property. For example, if you sold your home and handed the cash to your child to buy a home for you all to live in together, Revenue & Customs would work out what share of the property came from your gift, add the annual rental value of that share to your income and charge you income tax on it.

It is effectively billing you for the benefit it deems you to have received. On the average UK rent of £1,126 a month, according to Zoopla, this would amount to a tax charge of £2,702 a year (or more for higher rate taxpayers). Over a ten-year period, that amounts to £27,024.

3. Make half-hearted gifts - £3,500 hit
If you make a gift, ensure you do it properly and formally. For example, if you hand over a painting, do so physically – even if it means leaving an unsightly space on your wall.

You should also make sure the beneficiary adds it to their home insurance – and you take it off yours – so there is evidence that the gift has been made.

Mike Warburton, a former tax director at the accountancy firm Grant Thornton, says "there is a temptation, for example, to say after your parents have died that their valuable Old Master had been given to you seven years ago. Contrary to some rumours, tax inspectors are not stupid. Apart from the insurance issue, when the solicitor handling the estate calls round, what is your answer for the suspiciously clean patch on the wall where it used to hang?"

"Revenue & Customs will often investigate if gifts were made seven years before the giver died. It has access to huge amounts of personal information via a database called Connect," says Robert Levy, a specialist in tax investigations at law firm Kuits Solicitors.

There is no time limit on how long the taxman has to open an investigation into this. The interest charged on unpaid inheritance tax is currently 7.75%.

A penalty can then be added to this, depending on the reason for underpayment. Where a mistake has been made, or there was lack of reasonable care, families could pay up to 30% of the extra tax due. So if you had a painting worth £5,000, and failed to pay inheritance tax on it, after five years you would owe £905 in interest, £2,000 in the initial unpaid inheritance tax and £600 as a late penalty – amounting to £3,505.

4. Fail to put life cover into trust - £45,000 hit
Lfe insurance policies are often taken out to pay out to loved ones on the policyholder’s death.

But failing to set up the policy properly could needlessly land them with an inheritance tax bill. Life insurance policies can be put into trust, which means they are not included as part of your estate for inheritance tax purposes. However, nearly 7,000 estates paid inheritance tax on life insurance payouts in 2020-21, according to the latest data.

These life insurance policies were worth £830million, which means up to £332million of inheritance tax may have been paid unnecessarily.

Sean McCann of wealth manager NFU Mutual says "if a policy is not put into trust, it will be included in your estate. This means that up to 40% of the payout could be lost to the taxman from the outset. On a policy that pays out £100,000, this would amount to a £40,000 bill. Putting life insurance policies into trust is straightforward and many providers make trust forms available free of charge."

5. Put pension cash into savings - £10,000 risk
Pensions can be a very tax efficient way of passing on money to loved ones. They can be passed on tax-free if the giver dies before the age of 75.

If they are older, the beneficiary pays income tax when they subsequently withdraw money from the pension. However, pension holders often unwittingly jeopardise their tax-free status by needlessly withdrawing money from it and putting it into a savings account instead. Once money is out of the pension, it is no longer safe from inheritance tax. This is a problem because pension holders frequently take advantage of their right to withdraw a 25% tax-free lump sum from their pension whether or not they need the money.

McCann says ‘"many people take significant sums from personal pensions, often with no clear idea of what they intend to do with the money, with many choosing to put it straight into a savings account. It’s important to remember that money remaining in your pension on your death is normally free from inheritance tax, whereas savings accounts and most other investments are included when calculating an inheritance tax bill."

For example, if you took £25,000 from a £100,000 pension pot and put it into a savings account, your beneficiaries would face a £10,000 bill when they inherited it. Whereas if you had left it in a pension, they may not have had to pay a penny.

6. Miss joint allowance - £200,000 hit
Couples who are married or in a civil partnership can combine their inheritance tax allowances.

A single person has an allowance of £325,000, but a couple has one of £650,000 to be used on the death of the remaining spouse.

However, many people do not realise that widows or widowers retain their deceased spouse’s inheritance tax allowance even if they remarry. If you remarry, you can combine your inheritance tax allowance with that of your new spouse.

McCann says "many people who have been widowed and have remarried don’t realise they can potentially leave up to £1.5million free of inheritance tax. If their spouse was also widowed, they could leave up to £2million. It’s important for anyone who has lost a spouse and remarried to take advice to maximise the sum they can leave tax-free to their family."

For example, a widower who plans to leave the family home to his children could pass on a property worth £1million tax-free. His new bride would also have her own allowance worth £500,000, assuming she too wishes to pass on a family home. Together, they can pass on a tax-free estate worth up to £1.5million.

7. Fail to tie the knot - £70,000 hit
You may have been with your partner for decades, have a home together, children, and shared finances.

But you will only enjoy the inheritance tax benefits of a couple if you are married or in a civil partnership. If you own a property with your partner as joint tenants, your partner’s share will pass to you automatically if they die first.

However, their share still forms part of their estate for inheritance tax purposes so you may face a tax bill. If the property is worth £1million, their share would be £500,000 and so inheritance tax would be payable at 40% on the sum above their tax-free allowance of £325,000. That would amount to a hit of £70,000.

8. Unclaimed overpaid IHT - £40,000 HIT
Inheritance tax usually has to be paid within six months of a death and is based on an estimate of the value of deceased’s assets on the day they died.

If the executors sell a house within four years of the death at a lower value they can reclaim the overpaid IHT. Refunds are particularly common when house prices are falling, as the price achieved on a property is more likely to be less than had been expected. You can also claim back on shares and other qualifying investments that are sold at a lower value within 12 months of the death.

More than 5,000 families claimed a refund in the 2022-23 tax year after overpaying, official data shows. That is up 22% on the previous year.

McCann says "let’s take the example of someone who dies leaving significant assets, including a house worth £1million. Eighteen months after their death, the executors sell the property for £900,000. They could reclaim the inheritance tax on the £100,000 fall in the house price, resulting in a £40,000 reclaim for the beneficiaries.’