Only the richest four per cent of families pay inheritance tax, but many worry they could be dragged into its net – especially if there is a raid on wealth in the Budget.
Even though the vast majority of estates don’t get hit, it is still regularly dubbed Britain’s most hated tax.
And the Government is raking in ever-higher sums because frozen inheritance tax thresholds and the property price boom mean more bereaved people’s estates are becoming liable.
The latest HMRC figures show that from April to August this year estates have paid £3.5 billion, which is £0.3billion more than during the same period in 2023.
Although 4.4 per cent of estates paid inheritance tax in 2021/22 – or 28,000 out of a total 634,000 – receipts soared to a record £6billion.
So how do you work out if your family will have to pay inheritance tax under the current rules, and how might any Government changes in the Budget on 30 October affect you? We explain below.
How much is IHT and who pays?
Inheritance tax is charged at 40 per cent on assets above two key thresholds when people die.
To work out the size of an estate you need to add up the value of any property (minus mortgages), investments, savings and other assets.
You need to be worth £325,000 if you are single, or £650,000 jointly if you are married or in a civil partnership, for your loved ones to have to stump up death duties. This is called the nil rate band.
But there is a further allowance £175,000 individual allowance if you are worth more than this and leave your own home to your direct descendants. This is the residence nil rate band.
It increases the maximum threshold to a joint £1million if you have a partner and own your home.
Once an estate reaches £2million, this ‘own home’ allowance starts being removed by £1 for every £2 above this threshold. It vanishes completely by £2.3million.
This is Money’s tax columnist, Heather Rogers, explains ‘Many people are allowed to leave a further £175,000 worth of assets without them becoming liable for inheritance tax, if their home forms part of their estate and they leave it to direct descendants.
‘That means children, including adopted, step or fostered, and those children’s linear descendants.
‘This extra sum is what is called the residence nil rate band, and it is available to claim on deaths on or after 6 April 2017.
‘Both protected amounts or “bands”, adding up to £500,000 per person, can be transferred to a surviving spouse or civil partner if unused on the death of the first spouse.’
Heather Rogers has replied to many readers about inheritance tax issues – see below.
‘Inheritance tax casts a long shadow,’ says Sarah Coles, head of personal finance at Hargreaves Lansdown.
‘Millions of people are worried about the impact this tax could have on their family. Rumours of potential changes in the Budget in October have fuelled more inheritance tax anxiety.
‘Even those who fall well short of the current thresholds are worrying that tweaks to this tax could mean HMRC takes a big chunk out of their estate after they die.’
What could happen to IHT in the Budget?
Increasing the inheritance tax rate from 40 per cent
Coles says: ‘Fewer than one in 20 estates pay it, so it wouldn’t raise a vast amount of money. If you hit the wealthy hard, they’ll pay for expert help to cut their bill, so it could limit the gains even more.’
Changing nil rate bands
The residence nil rate bands exclude people without children who leave their estate elsewhere – often to other family members like siblings or nieces and nephews.
If the Government wants to stop penalising the childless, it could make the residence nil-rate band available to them too, or axe it and raise the nil rate band to £500,000 for everyone.
But it could get rid of it and make the threshold £325,000 for everyone, or set it at some new level in between that and £500,000.
Levying inheritance tax on pensions
Beneficiaries either pay no tax on inherited defined contribution pension pots up to the deceased’s lifetime allowance limit, if the owner dies before age 75, or their normal income tax rate if they are 75 or over.
The last Government considered levying income tax on withdrawals from pensions inherited from younger savers too, but eventually dropped the idea.
Coles says a change would not affect people who use their pension to buy an annuity, or have defined benefit pensions, or who plan to spend their pension within their lifetime.
‘It will largely affect those with larger estates who don’t spend their pensions – either because they pass away earlier than expected or because they have used their pension to help cut their inheritance tax bill.’
> What could happen to pensions in the Budget?
Rules for spouses and married partners
‘Anything you leave to your spouse or civil partner is free of inheritance tax, and if you pass everything to them after your death, you also pass your nil rate bands,’ says Coles.
‘It means when the second person in a married couple dies, they can leave assets worth up to £1million free of tax.’
Changing agricultural and business property relief
These reliefs mainly benefit the very wealthy, and you should see a financial adviser before using them to mitigate inheritance tax.
The Government might well decide to tighten up the rules in these areas, but it will want to avoid harming family farm owners and smaller family businesses.
Deterring entrepreneurship or funding for start-ups would also conflict with its mission to promote economic growth.
How to beat inheritance tax
Sarah Coles of Hargreaves Lansdown runs down some of the options.
– If you’re worried the Government might cut the nil rate band, you can give up to £3,000 away before the change, which will fall within your annual gift allowance.
– You can give away larger sums and they will be outside of your estate after seven years. There’s a separate rule that means you can give away surplus income inheritance-tax free too.
– If you have children in your life who are under the age of 18, you could consider paying £3,000 into a Junior Isa for them each year.
You can pay up to £9,000 into Junior Isas each year, but a portion of this would only fall out of your estate after seven years.
– If you’re investing in qualifying AIM companies, and plan to take advantage of the inheritance tax break, this isn’t necessarily a signal to sell.
If the Government removed the tax break entirely, it would mean bringing in retrospective taxation, and could seriously damage investment in smaller, listed businesses.
It means it might consider alternatives, such as changing the qualifying period. If the investment is otherwise right for your portfolio, it doesn’t make sense to rush into a decision to sell.
– If you’re worried about capital gains tax treatment on death, it’s a good idea to realise capital gains each year if you can and move as many assets as possible into stocks and shares Isas during your lifetime, using the share exchange (Bed & Isa) process.
