Investing Taxation

Inheritance tax explained. All you need to know.

June 14, 2022
Inheritance tax explained. All you need to know.

In life, you are taxed on what you earn. You are then taxed on what you spend. If you decide to save or invest what is left, you are taxed again. And then when you die if you have managed to accumulate a chunk of money the government will try to tax you on this as well.

In this article, we focus on taxation after you die. This is called inheritance tax. We explain how it works and more importantly what you can do to avoid it.

What is inheritance tax?

Inheritance tax is the name the government gives for the tax it levies against your estate when you die. When the day of reckoning finally arrives your money will get held in probate. The executor will need to calculate any tax due. This tax then needs to be settled before the beneficiaries of the estate can receive what’s left. The tax you pay is inheritance tax.

What is probate?

Probate is the term used to describe the legal and financial processes involved in dealing with the assets of a person who has died. These assets can include property, money, and possessions. If your estate totals more than £5,000 then it is likely that probate is needed.

Probate is the process of proving that a will is valid (if there is one) and confirming who has the authority to administer the estate of the person who has died.

Before the executor named in the will, (or the next of kin if there is no will) can claim, transfer, sell or distribute any of the assets in the estate they need to apply for a grant of probate. This is a legal document that’s often needed to access bank accounts, sell assets and settle debts after a person has died.

Once probate has been granted the executor will administer the will. This involves finding out all of the deceased assets and liabilities. The liabilities will then be settled. Once this has happened the value of the deceased estate will be calculated. If your estate is above the permitted threshold there is inheritance tax (IHT) to pay.

How is inheritance tax calculated?

Currently, each person is allowed to have an estate with a value of £325,000 before any tax is due. If your estate is valued above this level then there is a tax to pay. The one main exception is that you can pass over £175,000 from your main residence tax-free. This means your estate has a potential exemption of £500,000. Any value you hold over £500,000 will be taxed at 40%. This threshold will remain until 2026.

If you have a spouse or partner this tax can be deferred until the other person dies. This means that couples have a potential £1 million IHT exception if their main residence is valued at over £350,000. With the average property in London worth well over half a million, this threshold is easily breached.

Impact for investors

Many people invest to provide for their retirement. Some do this entirely through a pension fund. Yet, with annuity rates at near record lows many people are seeking to invest for their future in other ways.

Investment via buy-to-let properties is a strategy that many use. A buy-to-let investment can offer a yield higher than an annuity rate. The property will usually outperform inflation so your money won’t erode. You then also have an extra asset that you can pass to your kids. This makes property investing very attractive to investors.

One problem when deciding to leave a legacy is the IHT that will need to be settled from your estate. Investors who have been careful with their earnings and have invested wisely to leave a legacy for their children, resent a tax that is levied at 40%. As a result, many investors seek ways to minimise this tax obligation.

What is the average IHT bill?

Whilst several people don’t pay IHT, the average bill for those that do is more than £200,000. With a rising property market coupled with the IHT threshold not rising until 2026, there are many more people who will be affected. The chart below shows that the IHT threshold has not risen since 2009 but the value of money has diminished. This means that in real terms we are being taxed more for passing down wealth.

IHT tax threshold rate freeze

There are ways you can mitigate this tax, but you need to make provisions early. In the ensuing section we explain what you can do to minimise your IHT obligation.

How do I avoid inheritance tax?

Let’s get into the nitty-gritty of the article and show you what you can and perhaps should do to minimise your IHT.

1. Make a will

Making a will won’t remove your IHT. However, a will can make sure that your estate is distributed in accordance with your wishes. Failure to make a will results in laws of intestacy being applied. You can find out about intestacy rules here.

2. Keep you assets below the threshold

This seems obvious and it is. If you know that your assets are above the limit you can do a number of things to bring your estate below the threshold.

  • One way to do this is gifting. You can gift £3,000 from your estate each year without any fees to pay.
  • If you gift a larger sum it can still be potentially exempt. Though this can take up to seven years. If for example, you gift a property to a child whilst you are alive the clocks start ticking from when you gift the property. If you survive seven years there is no IHT. However, if you die before it will still form part of your estate. But this could be a lot lower, as there is what’s called taper relief. After 3 years the percentage of the asset reduces in value by 20% per annum until it is fully exempt. You can find more information on IHT through the appropriate guide on our website.
  • It should be pointed out that if an asset has appreciated significantly in value (such as a property) and then you decide to gift it away you could be subject to capital gains tax. This is usually levied at 20% minus the capital gains tax allowance. So if you bought a property that has gone up by £50,000 you are subject to a £7,540 CGT bill. You can find out more about current tax rates and exemptions on our tax card.

3. Put your assets into a trust

By placing assets inside a trust you are removing them from your estate for tax purposes. There are several ways you can structure a trust. One way is called an interest in possession trust. This way allows you to receive the income from the asset whilst simultaneously placing the asset outside of your estate. As such many people structure property this way. It should be pointed out that trusts are complicated and the above example is a simplification. As such, it is wise to speak to a tax specialist.

4. Buying property through a limited company

Buying a house as a limited company can minimise your family’s inheritance tax burden after you die, by making them shareholders in your limited company.

Furthermore, if you have a family business and property purchases could also qualify for business relief for inheritance tax. Whichever way you choose to do it, it’s essential to get good financial advice.

Free financial review

At Esper Wealth we offer all prospective investors a free investment review before they buy a property through us. This service is designed to help you get the best advice for any prospective investment. We start this process by finding out what is important for you, in so that we understand your specific investment needs. This way we can tailor any advice to suit your financial requirements. Part of this process includes observing your tax situation. We can guide you on important issues such as capital gains tax, inheritance tax and stamp duty. If you would like to know more about how we can help you, then contact us today.