BackToBasics
The principles of inheritance tax
First Intuition’s Nick Craggs breaks down the basics of inheritance tax and how it functions
Words: Nick Craggs, First Intuition Illustration: Michał Bednarski
The principles of inheritance tax
First Intuition’s Nick Craggs breaks down the basics of inheritance tax and how it functions
Words Nick Craggs, First Intuition Illustration Andrew Nye
They might not like it, but few people would argue that income tax is wrong and that the world would be a better place if it didn’t exist. However, inheritance tax (IHT) is probably one of the most divisive taxes around. Some people are huge advocates for IHT and others think it is morally unjust. I don’t have enough words to get into that, nor am I brave enough to! However, I do think that everyone should have an understanding of the basics of IHT, as it is something people might not worry about and, if it affects you, can be an eye-watering amount of money.
Death and taxes
The main thing most people associate with IHT is that people get taxed when they die, on things they own at the time of their death. This is true, but this is not the only time you might pay IHT – and not the only thing you might pay it on as well.
IHT is mostly taxed at 40%, which can lead to a large tax bill. Taking nearly half of what someone owns on their passing in tax might seem a bit harsh, so HMRC allows you an amount that won’t lead to an eye-watering tax bill. This amount is known as the nil rate band. Since 2009, the nil rate band has been £325,000. Any amount up to this is taxed but at a rate of 0%. Only the amount of a person’s estate above this amount is taxed at 40%. In an example of someone who dies with an estate of £500,000, they will pay 40% tax on the £175,000 above the nil rate band.
We all know how much house prices have risen in the last 15 years, but the nil rate band hasn’t moved at all. This means more and more houses have been subject to IHT. HMRC has made an allowance for this, though, so families are less likely to have to sell the family home just to pay an IHT bill. If you leave your home to a lineal descendant, which is a child or grandchild, then there is an additional nil rate band of £175,000. This could potentially mean an amount of £500,000 that would be taxed at 0%, as long as the house the deceased person lived in is left to a child or grandchild.
Key point
It's important as an accounting technician to have a working understanding of inheritance tax, as it can become very stressful for clients to deal with if they have not experienced it before – particularly if there are large sums involved.
People need to be aware that items that have been given away in the seven years before they die can also be subject to inheritance tax.
The seven-year rule
We have talked about the things that most people think will be subject to IHT, which are the items the deceased person owns when they die. However, people need to be aware that items that have been given away in the seven years before they die can also be subject to the tax. This is so someone cannot get bad news from the doctors and then quickly give everything away before they die to try and avoid IHT.
When calculating the IHT payable when someone passes away, you need to go back seven years and identify any gifts as these are also going to be subject to IHT. This is easier said than done, however, and there are a number of exemptions that mean you don’t need to identify every time someone gave a grandchild £10 for their birthday. Once someone has lived more than seven years after they gave something away, you can assume that they didn’t give it away just to avoid IHT.
Taperingy
Some of you might be thinking that the seven-year rule is a bit of a cliff edge. If someone dies six years and 11 months after making a gift then this could be taxed at 40%, whereas if they live for just one more month then it is completely tax-free. To make this fairer, HMRC has a system known as taper relief. This reduces the amount of tax payable on that gift, depending on how long the person lived after the gift was made. If someone lives more than three years after the gift, but less than four years, then the gift is still taxed at 40%. However, only 80% of this tax is payable. The amount of tax that is payable decreases by 20% for every year that someone lives after three years, until they have survived seven years.
If someone lives between four years and five years after making a gift then the tax payable is reduced to 60%, then 40% if they live between five and six years, then finally reduced to 20% if they live between six and seven years after making the gift. Say, for example, someone gave away £200,000 and lived four years and seven months before they passed away. If we ignore the nil rate band, this will be taxed at 40%. But because they lived between four and five years, the tax will be reduced to 60% due to taper relief. This gives IHT payable of £200,000 x 40% IHT x 60% due to taper relief of £48,000.
Remember, this is just the tax on that particular gift that is reduced. Different gifts might have different rates of taper relief, and this doesn’t apply to anything the deceased owned at the time of death, or gifts made less than three years before the date of death.
There is a lot more to IHT than this – and this is very much not tax advice. However, you have probably heard the phrase about the only two certainties in life, so you might want to think about both!
Quiz time
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