An inheritance tax is dreaded (and often hated), but the reality is that very few estates pay it. Data from HM Revenue and Customs (HMRC) shows that while it earned £ 5.2bn in inheritance tax in the 2019-20 tax year, only 3.8% of all deaths resulted in an invoice.
That said, it is only fair that you take this into consideration when planning to distribute your estate. We’ll start with the basics of inheritance tax, as it’s important to understand the fundamentals when planning.
Inheritance tax is charged at 40 percent of your estate. This rate can be reduced to 36 percent if you donate ten percent of your estate to charity. It is deducted from the excess of your “zero rate bracket” – a tax-free inheritance allowance. This is made up of two parts, but not everyone is eligible for both. The main zero rate bracket is £ 325,000, accessible to everyone. The second part is only available to people who have included a property in their estate, which is inherited by a “direct descendant” – a child or grandchild. In the current tax year this amounts to £ 175,000, which means the total you could give tax-free is £ 500,000. Anything over this amount is subject to inheritance tax.
If you are married or in a civil partnership, your partner can inherit your entire estate tax-free, as well as your tax-free allowances. Combined with theirs, this could allow a couple to donate £ 1million tax-free. However, the benefits start to diminish if your estate is worth more than £ 2million.
So, make way for gifts. This can be an effective way to reduce a possible inheritance tax bill and reduce complexity for your heirs. Everyone has an annual gift allowance of £ 3,000 per tax year, and if you don’t use your allowance you can carry it over once, allowing you to donate £ 6,000 in a year. You also have a small gift allowance, which allows you to give unlimited gifts of up to £ 250 to a person without being subject to inheritance tax, although they cannot go to anyone who has benefited from your annual gift allowance. You can also give up to £ 5,000 for children and £ 2,500 for grandchildren for weddings (as well as £ 1,000 for anyone else).
If the money you donate isn’t one of them – and in your case it is – you do something called a potential exempt transfer. As you rightly point out, if you die within seven years of one of these donations, it will be added to your estate and inheritance tax could be due if your estate exceeds your tax allowances.
The amount of tax payable decreases as you survive this seven-year period. If you die within three years of the transfer, a 40% rate will apply, which increases to 32% if you die within four years, and then to 24%, 16%, and 8% each year, respectively, after that. This is called the conical relief.
However, most donations do not become taxable as the £ 325,000 allowance is given to donations made within seven years of the donor’s death before the remainder of the estate. This means that the bill will go to those who inherit most of your estate when you die, rather than those who received gifts during your lifetime.
I suggest you discuss this with your family and keep a record of your donations – not only will everyone be clear where and why your money has gone, but it will make the administration of your estate easier. Hopefully not for many years!