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Inheritance tax explained

Many people have a limited knowledge of inheritance tax but it is a very important issue to consider when making a will. Taking it into account or failing to do so can either save your loved ones thousands of pounds or cost them a great deal of money.

Definition

Inheritance tax is a tax on the money or possessions that you leave behind as well as some of the gifts made during your lifetime. However, it is only applicable after a certain amount so, depending on your assets, you may not need to pay it at all.

In cash terms

The current limit is £325,000 so any money, property or possessions up to that limit will be free of inheritance tax, this amount is known as the tax-free allowance or the nil rate band. That £325,000 limit is likely to remain for the foreseeable future, until 2017 at least.

The tax, when it is paid, is 40%. Therefore, if your estate is worth a million pounds, the amount to be taxed would be £675,000 because the first £325,000 is exempt. Of that £675,000 the amount taken off due to tax would be £270,000, leaving the estate to be worth, after tax, £730,000.

In many estates much of the value is in property, often the family home and, as an inheritance tax bill is due to be paid within six months of the person passing away, in some cases this may mean the home having to be sold to pay off the amount.

Married couples

Rules which were introduced in 2007 have changed the way inheritance tax applies to married couples and civil partners. The surviving spouse or civil partner can increase the threshold on their estate as transfers between married couples or civil partners are not subject to IHT. Therefore, they can pass on unlimited amounts as long as the person receiving the assets has their permanent home in the UK.

Therefore, when one of the married couple dies, if the estate passes to the remaining spouse the £325,000 tax threshold is not used and so, when the other spouse then dies at a later date, their estate will be worth up to £650,000 before they are subject to inheritance tax, in other words two lots of £325,000.

Other exemptions

Apart from married couples there are other instances where assets can be passed on without paying IHT, even if the value of the estate is over the £325,000 threshold.

  • Charity exemption - gifts to a qualifying charity are exempt from IHT.
  • Potentially exempt transfers – If a person survives for seven years upon making a gift to someone, that will usually be exempt for IHT whatever the value.
  • Annual exemption – Up to £3,000 a year can be given away without being made subject to IHT, either in one gift or several.
  • Small gift exemption – small gifts of up to £250 can be made tax-free.
  • Wedding and civil partnership gifts – these are also exempt from IHT up to a certain amount.
  • Business, woodland, heritage and farm relief – some relief from IHT may be available in these instances.