Think you know the truth about Inheritance Tax? Here are 4 common myths, busted

Inheritance Tax (IHT), often referred to as Britain’s most-hated tax, is a tax payable on your estate when you die. Your estate encompasses your property, money and possessions – your pension does not typically fall within the value of your estate.

With Professional Adviser reporting that IHT receipts are expected to hit a record high in the 2023/24 tax year, you may be worried about how this tax could affect you and your loved ones in the future.

Crucially, there are many misconceptions around exactly how IHT works, who has to pay it, and what you can do to potentially mitigate it.

To help you gain a better understanding of IHT, read on to discover some common myths about this unpopular tax, and why they’re not entirely accurate.

1. “40% of my estate will be taxed when I pass away”

The standard IHT rate is 40%, so you would be forgiven for thinking that all of your estate will be taxed at this rate when you pass away. However, this is not the case.

Your estate is only liable for IHT if it is worth more than the “nil-rate band”, a threshold which as of the 2023/24 tax year is set at £325,000.

So, if your estate is worth less than £325,000 when you die, your family will not have to pay any IHT.

If your estate is worth more than the nil-rate band, IHT will only be payable on the tax liability over £325,000.

Additionally, if you leave your main residence to your children or grandchildren then you may benefit from a further threshold called the “residence nil-rate band”. This stands at £175,000 in 2023/24, taking the total amount your beneficiaries can inherit tax-free to up to £500,000.

Furthermore, if you’re married or in a civil partnership, and one of you or your partner dies and has not used all of their nil-rate band, the remaining threshold can be added to the other partner’s when they die. That means you may be able to pass on up to £1 million tax-free between you.

Normally, everything over these thresholds will then be taxed at 40%. However, there will be no IHT to pay if you leave your estate to a charity or a community amateur sports club.

It’s worth noting that these tax-free thresholds are frozen until at least 2028. So, as asset prices increase and you grow your wealth, you may see more of your wealth exceed the nil-rate bands over time.

2. “Inheritance Tax only affects the super wealthy”

While it is true that only a small proportion of estates will be subject to IHT – the most recent data from HMRC shows that only 3.73% of UK deaths resulted in an IHT charge – you do not have to be “super wealthy” to pay this tax.

If you own a property, especially if it’s a family home, it can be quite easy to cross the IHT threshold. Indeed, Zoopla reports that the average price of a detached house in the UK is £446,800. Even if you pass your home on to your children or grandchildren, you don’t need to own a property worth much more than this for your estate to potentially be liable for IHT.

So, it’s important to consider how you could mitigate the potential IHT payable on your estate, even if you would not class yourself as “super wealthy”.

One common way you could reduce the value of your estate now is by gifting to your family. However, there are even more myths associated with gifting and IHT, as you’ll see below.

3. “I can only give away £3,000 a year or my loved ones might face Inheritance Tax”

Gifting wealth is one of the most common ways that people seek to mitigate IHT. But, you might mistakenly believe that you can only give away £3,000 each year, otherwise your loved ones could face an IHT charge on your death.

The “annual gifting exemption” for IHT allows you to give away a total of £3,000 (or £6,000 as a couple) worth of gifts each tax year without them being added to the value of your estate.

You can also carry forward unused exemption from the previous tax year, meaning you could potentially pass on up to £12,000 between you and your spouse or civil partner in a single tax year and have it fall outside your estate.

These gifts can include:

• Money
• Household and personal goods such as furniture, jewellery or antiques
• A house, land or buildings
• Stocks and shares listed on the London Stock Exchange

• Unlisted shares you held for less than 2 years before your death.

Selling an asset for less than it’s worth also counts as a gift.

But crucially, it is possible to gift more than £3,000 in a year without your loved ones facing a potential IHT bill.

For example, you can give gifts to someone getting married or starting a civil partnership without paying IHT. The value of these gifts can be up to:

• £5,000 for a child
• £2,500 for a grandchild or great-grandchild

• £1,000 for any other person.

Gifts to your spouse or civil partner fall outside of your estate as long as your partner lives in the UK permanently.

Additionally, there’s an unlimited spousal exemption that applies where both parties are either both domiciled in the UK or both non-domiciled. This spousal exemption is limited to an amount equal to the nil-rate band where the receiving spouse is outside the UK.

You can also take advantage of the “gifting from surplus income” IHT exemption. This allows you to make regular gifts out of your income, such as for a child’s or grandchild’s school fees, which immediately fall outside of your estate for tax purposes. This also includes birthday and Christmas gifts.

Furthermore, you can also make as many small gifts of up to £250 per person in a year as you like, provided that they don’t receive gifts from you under one of the other allowances described above.

So, you could gift much more than £3,000 in a single tax year and have it fall outside the value of your estate.

4. “The 7-year rule means my loved ones will pay less tax if I make large gifts”

One other method you may have heard of for gifting to mitigate an IHT charge is the “seven-year rule”.

The seven-year rule means that if you die more than seven years after giving a gift, the value of the gift will not be included in your estate. That means you could make potentially unlimited tax-free gifts.

You may have also heard that gifts made under this rule attract a lower rate of IHT. But this is only partially accurate.

Your loved ones will usually face the full 40% IHT rate on gifts you make one to two years before your death. Then, gifts given three to seven years before your death may be taxed on a sliding scale known as “taper relief”. The sliding scale is as follows:

• 32% for gifts made three to four years before your death
• 24% for gifts made four to five years before your death
• 16% for gifts made five to six years before your death

• 8% for gifts made six to seven years before your death.

This leads many people to believe that gifting large sums may reduce the IHT bill their loved ones might face.

However, taper relief is only applied to gifts that exceed the nil-rate band of £325,000. So, if you still had your entire nil-rate band, a gift of £100,000, for example, would not necessarily be liable for IHT at all because it’s covered by your tax-free threshold.

So, in this case, you would not be saving your loved ones any money on their IHT bill as they wouldn’t benefit from taper relief.

To benefit from taper relief, you would need to use your entire nil-rate band first, and then make gifts in excess of it.

Get in touch

If you’d like to discover how you can minimise the potential IHT liability on your estate, please email info@douglaswhiteltd.com or call 0151 345 6828.

Please note

This article is for general information only and does not constitute advice. The information is aimed at retail clients only.

Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.

The Financial Conduct Authority does not regulate estate planning or tax planning.

Remember that taper relief only applies to gifts in excess of the nil-rate band. It follows that, if no tax is payable on the transfer because it does not exceed the nil-rate band (after cumulation), there can be no relief.

Taper relief does not reduce the value transferred; it reduces the tax payable as a consequence of that transfer.