Inheritance Tax (IHT) can often be a major worry for people when it comes to their financial planning, with people often not wanting to pass further wealth on to HMRC, having worked hard to accumulate it, but there are often many misconceptions when it comes to IHT.
As of 2019/20, individuals have a standard nil rate band of £325,000. There is an additional residence nil rate band that can apply where the main residence is left to a direct descendant (which also includes step children and adopted children). Currently this is £150,000 and will increase to £175,000 from 2020/21 but can only be used against the main residence. Therefore, if an individual’s share in a property is below the residence nil rate band, they can only use the allowance up to the value of the property.
Both of these allowances can be inherited by a surviving spouse. This would give married couples or civil partners a tax free band of £650,000 plus the value of the main residence up to £350,000 from 2020/21 (any house value above this level can be applied against the standard nil rate band).
It should be noted however, if an individual’s estate is valued above £2 million, the residence nil rate band is tapered away at a rate of £1 for every £2 over this threshold. Any inherited residence nil rate band would not be tapered away. The value of the estate for the purpose of this calculation includes assets that may not be liable to IHT, such as those qualifying for business relief or agricultural relief on death.
Leaving Part of the Estate to Charity on Death
On death, any estate above these nil rate bands and not subject to any exemptions would typically be taxed at a 40% rate. If 10% of your estate above the nil rate bands is left to charity, then a rate of 36% would apply instead and the charitable gift would be exempt. An example of how this works is shown below.
A widow passes away during 2020/21 tax year, having inherited everything from her spouse previously. Her estate is valued at £1.5 million, including a property value of £500,000. She leaves everything to her only child.
She would therefore be able to use two nil rate bands and two residence nil rate bands against the estate, meaning there is £1 million that can be passed on free of IHT. The remaining £500,000 would be liable to IHT at 40%, so the IHT that would be due is £200,000 leaving the child with an inheritance of £1.3 million.
Now let’s consider the widow decided instead to leave 10% of her ‘net estate’ (the estate after the deduction of the nil rate bands) to charity in order to reduce IHT to 36%.
The first £1 million would again be passed on free of IHT. Of the remaining £500,000, £50,000 (10%) would be left to charity with the remaining £450,000 liable to IHT at a rate of 36%. Therefore, of the £500,000 above the tax free bands, the IHT that is due is £162,000, the child would receive £288,000 and £50,000 would be left to charity.
The child’s inheritance in this scenario would be £1.288 million, which is only £12,000 less as a result of the £50,000 charitable donation.
How to Effectively Plan for IHT
IHT planning is rarely a one off, with ongoing reviews required to make sure the planning is still appropriate. This is especially true as capital values of assets will change over time, as will personal and family circumstances. In addition, legislation can change that may alter the effect of any previous planning that has taken place.
As part of an effective IHT planning strategy, this area should be looked at in conjunction with an individual’s will to ensure that all available nil rate bands are being used.
During your lifetime there many effective ways to mitigate IHT with each method having its advantages and disadvantages. Ultimately planning will need to be appropriate to your own circumstances and each potential avenue should be explored. We will discuss these different methods of mitigating IHT in later articles.