In the year ending 31 October 2015, HMRC received a total of £4.2 billion through the Inheritance Tax of the British public. In the year ending 31 October 2016, a total of £4.7 billion was received, an increase of 11.9% and a record high in Inheritance Tax receipts. Factors contributing to this include current the inheritance tax threshold of £325,000 (known as the nil rate band) being frozen since 6 April 2009. Couple this with increasing house prices, particularly around London, it means more and more estates begin to come into the scope of Inheritance Tax which might not have been before.
This has been addressed for some individuals who will benefit from the Residence Nil Rate Band (RNRB) which comes into force on 6 April 2017. Providing an individual leaves residential property to their spouse or civil partner or to children or grandchildren then their estate will have the benefit of an additional tax free allowance of £100,000 in the first year. This will then rise by £25,000 per year until the RNRB reaches its maximum of £175,000 per individual on 6 April 2020. The result of this will be that a married couple with children will have the potential to leave an estate of £1 million without paying Inheritance Tax from 6 April 2020. However, there is a ceiling where the RNRB does not apply. If an estate exceeds £2 million (the “taper threshold”), the relief is withdrawn by £1 for every £2 that the net value exceeds £2 million.
While the increase in house prices can be beneficial for the older generation in boosting the total value of their estates, it has also left the younger generation more dependent than ever on their parents and grandparents to help them get a foot on the property ladder. Consequently, there is a growing desire from some people to pass wealth onto the next generation during their lifetimes. While most people are not pleased with giving a chunk of their estate’s value away in Inheritance Tax, most are not aware of some simple ways in which it can be avoided or reduced. As a result, many fail to undertake any estate planning and end up leaving a hefty Inheritance Tax bill.
So, what is Inheritance Tax?
When someone dies, the estate they leave behind may be liable to Inheritance Tax. This is a form of tax applicable to estates with a total value which exceeds the nil rate band once the liabilities such as the funeral account, mortgages and other debts have been deducted. The assets of a deceased person’s estate will include their property, savings, valuable heirlooms, vehicles and even shares in a business. If the value of the estate falls beneath the nil rate band, there will be no Inheritance tax to pay. However, if it does, the tax liability will be 40% of the value exceeding £325,000.
For example, based on current figures, if John Smith passed away and left behind an estate worth £875,000 to his three children, £550,000 of this would be taxed at a 40% rate.
That means £220,000 of the total would go to HMRC leaving £655,000 to be divided between 3 children who would each receive £218,333.
So, while John Smith has attempted to pass on his wealth to the next generation, the largest individual beneficiary in this situation is HMRC.
The first mistake is to assume you don’t need to consider Inheritance Tax planning until well into your senior years. If you know your estate will exceed the nil rate band and RNRB then there are steps you can take during your lifetime to either avoid Inheritance Tax completely or significantly reduce the liability. The sooner you start planning, the greater your potential savings.
Exemptions and Reliefs on Gifts
Making gifts during your lifetime can be a simple way to reduce the value of your estate and therefore your potential inheritance tax liability. There are many Inheritance Tax reliefs and exemptions available on making gifts, some of which are described below.
- Spouses and civil partners are exempt beneficiaries for Inheritance Tax, providing they are both domiciled in the UK. This means there will be no Inheritance Tax to pay on any gift to a spouse or civil partner both on death by your Will and during life.
- Charities are also exempt beneficiaries for inheritance tax and gifts to charities are exempt from Inheritance Tax in the same way as gifts to spouses. In addition, if you leave a gift of more than 10% of your estate to a charity in your Will then the remainder of your estate will be subject to tax at the reduced rate of 36% rather than 40%.
- If you wish to make gifts to someone other than your spouse, you have an annual exemption of £3,000. It isn’t much, but it can reduce your inheritance tax liability over time. This could be particularly useful if your estate falls just above the threshold (e.g. £340,000) as it will allow you to gift £3,000 each year for 5 years until your estate is worth exactly £325,000. However, your annual exemption cannot be stocked up, you can only use the current year and the previous year’s unused annual exemption to reduce your tax liability. It is also possible to make gifts above this amount if they are made from surplus income, but these must be carefully documented to make sure the relief can be claimed.
- Another way of reducing your tax liability is to make gifts to your children or grandchildren upon marriage. If your child is getting married, you will be able to pass on up to £5,000 of your estate as a tax free gift. Grandparents will be able to make tax free gifts of up to £2,500 and any other friends or relatives can gift up to £1,000. This gift can also be combined with your annual exemption, meaning parents could make a gift to their child of up to £11,000 upon marriage.
- If you start planning early enough, significantly larger gifts than £3,000 can be made with no inheritance consequences. A gift to an individual or to a bare trust, for a beneficiary under 18 years old, which exceeds £3,000 will drop out of your estate for inheritance tax purposes providing you survive for seven years from the date of the gift. For example, John Smith this time makes a gift to his three children on 1st January 2017 of £50,000 each. Providing he survives until 1st January 2024, those gifts will not be taken into consideration when calculating any inheritance due in his estate. Even if he did die in that time, there would not be any tax to pay by his children, all that would happen is that John Smith’s available nil rate band is reduced by the £150,000 total values of the gifts.
These examples of gifts that can be made are useful ways for individuals to reduce the size of their estates and accordingly reduce their exposure to inheritance tax.
However, no action should be taken without seeking specialist advice to ensure that any gifts are appropriate to your circumstances. These examples are only a small snapshot of the various inheritance tax exemptions and reliefs available to individuals. If you are motivated to consider tax planning, the solicitors in the Wills, Trusts, Probate and Tax department at Preston Redman are fully experienced in advising clients in all circumstances, and would be pleased to meet with you to consider your options.