What is inheritance tax? How to plan for you and your family

Inheritance tax can be a complicated process. Our expert financial journalists break down what you need to know and how to plan for your family

House held in hands
(Image credit: Getty)

Inheritance tax used to be considered a tax on the ‘rich’, but with rising property prices, more families could be left facing a tax bill.

The latest Government figures show inheritance tax receipts from April to August this year were £2.7bn—that’s 35%, (£0.7bn), higher than the previous year.

“This is as a result of the pandemic and higher property prices dragging estates into the inheritance tax net”, says Andrew Tully, technical director at financial company Canada Life. “People may not realize the value of their property or indeed the overall value of their estate”.  

According to Zoopla’s ‘Hidden Equity Survey’, over a million homes are worth over £100,000 more than their owners realize.  And when it comes to rising property prices, the Halifax House Price Index, shows they’ve gone up 7.4% over the past year, and over half a million homes are now worth at least £1 million, according to Savills estate agency; an increase of 8% over the past year.

Inheritance tax can be complicated, so here’s what you need to know about how it works and how to save money.

What is Inheritance Tax?

It’s a tax on the ‘estate’ of someone who’s died, and for tax purposes your ‘estate’ means everything you leave behind, including property, cars, money and possessions.  

Whether any inheritance tax (IHT) is due depends on how much you’re worth.

How much inheritance tax do you pay?

There’s usually no inheritance tax to pay if the value of your estate is under £325,000 (known as the ‘nil rate band’), or you leave everything over this amount to your spouse, civil partner, a charity or community amateur sports club.   

Unless this is the case, anything over the £325,000 limit, can incur inheritance tax, which is charged at the rate of 40%, however, there are other allowances and exemptions. 

Couples can transfer any unused ‘nil rate band’ to their surviving partner, which doubles the tax-free threshold to £650,000, when passing on assets. And there’s also a tax-free allowance, known as the ‘Residence Nil Rate Band’, that applies when passing the family home to ‘direct’ descendants, including children, grandchildren, adopted, foster, and stepchildren.

“The residence nil rate band is worth an additional £175,000 on top of the Inheritance Tax threshold of £325,000”, says Andrew Tully. “This means an individual can pass on their estate inheritance tax-free if it’s valued at less than £500,000, or for a couple £1 million”.  Both allowances are frozen until April 2026.

Valuing an estate for Inheritance Tax

If you’re valuing an estate for inheritance tax purposes, you’ll need to get current valuations on everything from property to savings and valuables. 

With property and cars, this may be straightforward, but you may need to contact companies individually to find out the value of investments or seek professional advice if the deceased had more complex affairs, say owning a company. 

“Make sure your family keeps records of how they worked this out as HMRC can ask to see records up to 20 years after inheritance tax is paid”, says Colin Dyer, client director at investment company Abrdn.

How to save on Inheritance Tax

You can minimize or wipe out any potential inheritance bill by ‘giving away’ or ‘gifting’ money or possessions while you’re still around, which reduces the value of your estate.

Under Government rules, you can gift up to £3,000 each tax year, known as your ‘annual exemption’. “This might be £3,000 to one person, or you might opt to split £3,000 between multiple people”, says Colin Dyer. If unused; the allowance can be carried forward for a year to a total of £6,000. 

“You can also give as many gifts of up to £250 per person as you want each tax year, as long as you haven’t used another allowance on the same person” 

And you can also make additional gifts for weddings; including up to £5,000 for a child, £2,500 to a grandchild or great-grandchild, and £1,000 to anyone else.

Any money left to charities or political parties is also free from inheritance tax.

It's worth knowing that while there’s nothing to stop you giving away larger amounts, say handing your kids a chunk of cash for a deposit on their first home, this will still count towards the value of your estate.

This means those benefiting could face a potential inheritance tax bill further down the line, unless you live for another seven years. If you die within seven years of giving them the money, HMRC uses a sliding ‘tapering’ scale to work out any tax liability due.  

You might also like...

The types of ISA you need to know about

What you need to know if you inherit

It’s usually the executor of the will who sorts out any inheritance tax due, and this should be paid within six months of the end of the month in which the person died.  

If you’ve inherited from a will, once you’ve gained control of the asset, or assets, “normal tax rules apply”, says Andrew Tully, “so you would have to pay income tax on any dividends or interest from shares or cash, and capital gains tax on the disposal of shares if they’ve gone up in value since the person died”

“If you inherit property and already own a home, you’ll need to inform HMRC which is your main residence and if you sell the second property, having made a profit, then capital gains tax will normally need to be paid.”

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 as well as two books including ‘How to Get The Best Deal’.  

Cats, cheese and travel are Sue’s passions away from her desk, though as you might imagine she always looks for ways to see the sights for less!