Inheritance tax: what is it and how much will you have to pay?

If you're confused by what inheritance tax is as well as who pays it and when, you're not alone. This guide explains what you need to know

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Inheritance tax doesn’t only apply to those leaving behind country mansions and grand estates. With rocketing house prices and a freeze on tax breaks, more families will be left facing an inheritance tax bill when a loved one dies.

Unlike income tax, there’s no ‘sliding scale’, as inheritance tax is charged at a whopping 40% on everything you leave above a certain limit.

“Only around 4% of estates pay inheritance tax”, says Darran Harrison, wealth planner at financial services provider Kingswood.

“However the number of people caught in the inheritance tax net has soared by 35%, year on year, amid soaring house prices, and official figures from HMRC reveal a sharp rise in inheritance tax receipts, up £700 million compared to the same period last year, following the Chancellor’s decision to freeze the nil rate band in last year’s budget”.

As with many taxes, inheritance tax can be complicated so here’s what you need to know.

What is inheritance tax and who pays it?

Inheritance tax is levied against the ‘estate’ of someone who’s died. That estate basically means everything you’ve left behind, such as your home, car, savings and possessions.

If the deceased has left a will, they will have named an ‘executor’, who is in charge of dividing up that estate as laid out in the will, as well as valuing the estate and settling any inheritance tax due. 

The inheritance tax allowance  

Everyone enjoys an inheritance tax allowance of £325,000. The tax is only charged if your estate is worth more than this threshold, which is known as the ‘nil rate band’. 

This might seem like a vast amount, but the rate at which property prices are rising means far more people would now be subject to the tax. According to the latest house price index from Halifax, the average property is now worth £278,123. Throw in any investments or other assets and you could easily pass the inheritance tax threshold.

There are exceptions though. If you leave everything to your spouse or civil partner, then no tax will be payable. When they then pass on, their inheritance tax allowance will be combined with yours, meaning that you can pass on £750,000 to your loved ones before the taxman takes a slice.

Anything you leave above the threshold may be liable for inheritance tax, which is charged at 40%. Crucially, this is only payable on the portion above the threshold, while there are further allowances which can help you to leave greater sums to your loved ones.

Inheritance tax when leaving the family home 

If you’re passing on the family home, then another tax-free allowance ‒ the residence nil rate band ‒ may apply.

The residence nil rate band is worth £175,000 and can be added to the initial £325,000 nil rate band, meaning an individual can leave a total of £500,000 before their estate incurs inheritance tax. This increases to £1 million for couples.

It’s important to note that the residence nil rate band only applies when property is left to ‘direct’ descendants. This includes children, grandchildren, adopted and foster children as well as stepchildren.

Gifting away assets to reduce inheritance tax 

Bizarre as it sounds, money and assets that you have given away are still classed as being part of your estate if you die within seven years of the gift. Otherwise there is nothing to stop someone giving away their entire estate shortly before they die, avoiding inheritance tax altogether.

However, you do benefit from a host of gifting allowances which you can make use of to reduce the value of your estate while you’re still alive, and therefore cut any potential inheritance tax bill.

For example, there is the ‘annual exemption’ which means you hand cash gifts worth up to £3,000 in each and every tax year. The allowance can be used on one person, or split among several people, and if you don’t make use of it, can be rolled over for a maximum of one year, to a total of £6,000.

On top of the £3,000 allowance, you are allowed to make further gifts for family weddings, though the amount you’re allowed to give away changes based on your relationship with the recipient. You can give up to £5,000 for a child, £2,500 to a grandchild or great-grandchild and £1,000 to anyone else.

Any money you leave in your will to charities or political parties is also free from inheritance tax.

Inheritance tax and potentially exempt transfers 

But what if you want to give a loved one a larger sum of money, perhaps to help them put down a deposit when buying their first home? Be warned, there could be tax implications down the line.

“You can make larger gifts of money and these are called potentially exempt transfers (PETs) and can be made at least seven years prior to death. However, this comes with some conditions”, warns Harrison.

“One is that the assets must be an outright gift, rather than, say, loaned or a gift with reservation.  Another is that, should the donor die within the seven-year period, inheritance tax becomes payable on a sliding scale”.  

Tax rates for this are known as taper relief, and can range from the full 40% down to 8% depending on how quickly you die after making the gift.

Sue Hayward

Sue Hayward is a personal finance and consumer journalist, broadcaster and author who regularly chats on TV and Radio on ways to get more power for your pound.  Sue’s written for a wide range of publications including the Guardian, i Paper, Good Housekeeping, Lovemoney and My Weekly. Cats, cheese and travel are Sue’s passions away from her desk!