Your guide to Inheritance Tax

Inheritance tax, a financial concern for many retirees, can substantially impact the assets passed on to your loved ones when you die. Luckily, there are strategies you can employ to reduce your estate’s liability for it. In this article, discover what inheritance tax is and effective methods to reduce your liability.

What is inheritance tax?

Inheritance tax is the tax on the estate of someone who has passed away - this includes their property, money and possessions. Inheritance tax has existed in one form or another in the UK since 1694, when “Probate Duty” was charged at a fixed rate of 5 shillings on every estate worth £20 or more.

How much is inheritance tax?

Today, inheritance tax is paid on any estate worth over £325,000; anything over this threshold will be subject to a 40% tax. So if your estate is worth £400,000, your estate will be taxed at 40% on £75,000 of it, which is £30,000. It's also worth remembering that tax rates may be subject to change.

There are some exceptions - if you pass on your home to your spouse or civil partner when you die, there’s no inheritance tax to pay. If you want to pass on a home to someone else, this normally counts towards the value of your estate and could be subject to inheritance tax. However, your tax-free threshold can increase to £500,000 if you leave your home to your children (including adopted, foster or stepchildren) or grandchildren, or your estate is worth less than £2 million.

Who pays inheritance tax?

The person dealing with the estate will pay the inheritance tax; if there’s a will, they will be called the “executor”. Your beneficiaries (the people who will inherit your estate), do not normally pay tax on what they inherit.

When do you pay inheritance tax?

Inheritance tax must be paid at the end of the sixth month after the person’s death. If the tax is not paid by this point, HMRC will start charging interest, which will increase the value you have to ultimately pay.

The executors can choose to pay the inheritance tax on certain assets such as property through instalments over ten years, although it’s a good idea to pay at least some of the tax within the first six months. This is called payment on account, and is worth considering even if the valuation of the estate hasn’t finished because it will reduce the amount of interest that will be charged.

If an asset is sold before all the inheritance tax and interest is settled, the executors must ensure that all instalments and interest are paid.

How to reduce inheritance tax?

We’ve listed below a couple of ways you could reduce your inheritance tax bill, but it’s always worth speaking to a tax specialist for expert, personalised advice as it depends on your personal circumstances.

1. Ensure you have a will

Creating a will is one of the most straightforward methods to ensure your estate and assets benefit your loved ones as intended when you die. In the absence of a will, government regulations might dictate the distribution of your assets instead.

Furthermore, a will offers the opportunity to mitigate your inheritance tax liability. For instance, you can utilise your will to establish a trust, which constitutes a lawful agreement in which you entrust money, assets, or investments to another person to manage on behalf of a beneficiary. When you pass away, assets held within the trust are often exempt from inheritance tax.

2. Spend your money 

Often our spending reduces as we get older, but spending your money is a way to reduce the amount of inheritance tax on your estate when you die, as any cash savings or investments will also be liable. If you find yourself in a secure financial position with sufficient resources for the foreseeable future, your later years present an ideal opportunity to indulge yourself and your family.

This could be small actions like covering the expenses at a restaurant, funding driving lessons for your grandchildren, or booking a spa getaway. If you have quite a lot of cash savings put away, you could also gift some or all of the funds to your children or grandchildren to help them buy a car, get married or even put down a house deposit.

The younger generation of home buyers today are finding it harder than ever to buy their first home, especially with house prices rising faster than wages. Today, it takes the average home buyer 8 years to save up a deposit. While research from our mortgage partner Tembo Money suggests that a quarter of young adults will inherit more from their parents than they’d earn over 40 years of working.

Although this is good news for individuals poised to inherit substantial amounts, the majority will likely need to postpone their hopes of receiving such a substantial inheritance until they reach their 40s, 50s, or even later. Consequently, the prospect of purchasing a home could remain a distant aspiration until that time arrives.

Gifting inheritance early to your loved ones now could help them get on the property ladder sooner and start building up their own property wealth instead of renting. Plus, the greater your spending before your passing, the lower the inheritance tax on your estate will be later on.

If you have cash savings, you could gift them a lump sum to contribute to their deposit. If you give these funds to your loved ones as a gift (rather than offering them an informal loan) and live for at least 7 years, the money won’t be taxed when you pass away. For example, if you give away £100,000, this could potentially save your family £40,000 inheritance tax on your estate when you die.

Or alternatively, if you have amassed a large amount of equity in your home, you can use a Deposit Boost to unlock money from your property instead. The proceeds would be gifted to your child to boost their own down payment or could mean they don’t need to save up a house fund themselves, allowing them to potentially buy a property years earlier.

3. Pay for your funeral ahead of time

Planning and financing your funeral now will not only take this job off your loved ones’ hands, any money spent on your funeral won’t count towards your estate, so won’t be liable for inheritance tax.

4. Take out life insurance

Taking out a life insurance policy which covers an inheritance tax bill is another way to reduce the liability on your estate. If you place the policy in a trust, this ensures it will be paid outside of your estate on your passing.

5. Give generously

There are several rules surrounding inheritance tax which helps you to reduce your tax liability through gifting money. This includes transferring assets to your wife or husband, utilising the annual £3,000 gift allowance to pass money over to loved ones, or £2,500 to your children or grandchildren when they get married. You can also make donations to charities and political parties tax-free, both in your lifetime and in your will.

If you want to reduce the inheritance tax liability on your estate and help your child or grandchild get a foothold in the property ladder at the same time, Saga Mortgages can help. Our partner Tembo is an award-winning digital mortgage broker that specialises in helping the next generation of buyers increase their affordability so they can buy sooner, including family supported options. 

Remember, your home may be repossessed if you do not keep up payments on your mortgage.

Be careful of the 7 year rule!

Giving to your loved ones before your death can be an effective way to reduce the inheritance tax liability on your estate, but there are some rules to be mindful of. Gifts given less than 7 years before you die may be subject to tax, depending on who you give the gift to, the value of the gift and when the gift was given. This is known as the 7 year rule.

Gifts given in the 3 years before your death are taxed at 40%, while gifts given 3-7 years before your death are taxed on a sliding scale - this is known as ‘taper relief’. Taper relief only applies if the total value of the gifts made in the 7 years before you die is over the £325,000 tax-free threshold.

As well as keeping records and of when and whom you give gifts to, it’s also worth speaking to a financial advisor who can help you work out what you can give and how you can reduce your estate’s liability for inheritance tax on your death.