Inheritance tax: what is it and how does it work?

A beginner’s guide to inheritance tax

Sarah Pennells – Virgin Money Living Mentor

by Sarah Pennells | Independent Money Mentor

Founder of SavvyWoman and award-winning journalist


"Death, taxes and childbirth,” said Scarlett O’Hara in Gone With the Wind. “There's never any convenient time for any of them." While she was right, frankly my dear you have to give a damn. While inheritance tax may not be top of your party ice-breaker conversation list, it is vital to understand it – and the impact it can have on your family after you’ve gone.

What is inheritance tax?

First the good news: government figures show that over nine out of ten people never pay inheritance tax. To make sure you are with the majority you need to understand how the levy works.

Inheritance tax (IHT) is levied if someone leaves behind assets (such as their home, savings or investments) worth more than a certain amount once any debts have been repaid. It’s deducted after you’ve died and before anything you’ve left is passed on to those you’ve named in your will.

As with income tax, where you can earn a certain amount without having to worry about paying tax, you have an allowance before inheritance tax is applied. You can pass on assets worth up to £325,000 without it kicking in. This is called the inheritance tax threshold or ‘nil rate band’. Anything over that threshold could be subject to a flat rate of 40 percent, depending on who you leave it to.


What about my partner?

Husbands, wives and civil partners can leave as much as they like to each other after they die and there’s no inheritance tax to pay. The same doesn’t apply to couples who live together but who aren’t married or in a civil partnership.

If you’re married or in a civil partnership, you can also transfer your unused inheritance tax allowance to your other half. It’s a bit complicated, but worth getting straight in your mind. Let’s say you are married and have one child and your husband or wife died, leaving £25,000 to your child and the rest to you. When you die, those sorting out your financial affairs would be able to transfer £300,000 (the £325,000 allowance, minus £25,000 that was left by your late spouse to your child) to your inheritance tax threshold.

That would mean that you would be able to leave £325,000 (your IHT allowance), plus £300,000 (your late spouse’s) to your child, without there being any inheritance tax to pay. So you’d be able to leave £625,000 tax free.


Inheritance tax and your home

From April 2017, there’s a new inheritance tax allowance. It goes by the clunky title of the residential nil rate band (RNRB) and it’s being phased in over four years. It means that by April 2020, married couples or civil partners will be able to pass on property worth £1 million (that’s an extra £175,000 per person), and not pay inheritance tax. A single person will be able to pass on £500,000 with no inheritance tax.

But (and it’s a big ‘but’), you can only take advantage of this extra allowance if you leave your property to your direct descendants (children, grandchildren, great grandchildren etc). The property must have been your residence at some point, so buy-to-let properties will not be included, and if you have more than one home only one will qualify. Also, the extra allowance reduces if your property is worth £2 million or more.


How to bring down your inheritance tax bill

There are things you can do – quite legally – to reduce your inheritance tax bill. They don’t have to cost a lot and you don’t have to be wealthy to do them. The options include:

1. Giving money away while you’re alive: You can give away a certain amount every year, or give away larger gifts and, as long as you live for at least seven years afterwards, there’s no inheritance tax to pay.

2. Leaving money to charity: Any money you leave to charity is free of inheritance tax.

3. Passing on things you own via a trust: There are different types of trust. Some of these are expensive and others are much more straightforward. It can be worth considering a trust for policies such as pensions and life insurance.

4. Using life insurance to pay inheritance tax: Here, rather than try and reduce your inheritance tax bill, you take out a life insurance policy to pay it.


When do you pay inheritance tax?

When you die, the people who sort out your legal and financial affairs have to pay inheritance tax before any money, property or other assets can be passed on. If you die with a will, it’s the executors who do this. If you don’t have a will, they’re called administrators.

Any inheritance tax that’s due must be paid within six months of someone dying.

If you wish to find out more about Inheritance Tax, the Money Advice Service has a guide which covers the basics.

So there you have it. Death and taxes: inevitable but open to some light tweaking.


Before making financial decisions always do research, or talk to a financial adviser. Views are those of our mentors and customers and do not constitute financial advice.