How Does Inheritance Tax Work?

The Investment Board: Inheritance tax is one of the most hated of all taxes. We explain how it works and how much your estate could be liable for

Holly Black 6 March, 2020 | 9:37AM



Holly Black: Welcome to the Morningstar Investment Board. I'm Holly Black. Today, we're talking about inheritance tax, the dreaded IHT.

This is the most hated tax in the UK without a doubt. So many people will spend so much time worrying about this or plotting how to avoid it. And that is despite the fact that actually only about 5% of estates will end up paying this.

Now, I say estates not individuals because remember, IHT doesn't become a thing until after you die. So, this is about your estate, not you. And your estate is the value of all the assets that you own, such as your home, your savings, investments, any money you've got shoved down underneath the sofa, that all goes together to form your estate and that is the thing you're passing on to friends or relatives or whoever.

So, you do get a tax-free allowance. Your assets can be worth £325,000 before any inheritance tax is paid. Anything over this amount is taxed at 40%. But if you have £325,001, you would only be taxed on the £1. You still get the allowance.

So, as an example, let's imagine you have an estate worth £400,000. When you're thinking about passing that on, we minus off your tax-free allowance. That leaves us £75,000 on which the tax has to be paid. So, that's a £30,000 tax bill. That is a big tax bill. I will not lie. But it does still leave you £45,000 of that to pass on plus your £325,000. So, you can pass all of that on tax free. So, it's not bad.

And there is an additional allowance that came in a few years ago as a way to recognise the property prices in the UK have been rising for years and the most valuable thing you own is probably your home, but you're not actually sort of in charge of how that has grown in value. So, the government wanted to recognise that. They bought in a property allowance which goes on top of this. It's been sort of phased in and is creeping up. From April 2020 that allowance is £175,000. So, that is on top of this. As long as you're passing on the property to your children or grandchildren, you're eligible for that. So, that's effectively £500,000 you can pass on tax-free. It's quite a huge sum.

And there is a third, the perk here. If you are married, assets transferred between spouses are not IHT eligible. You inherit your spouse's assets tax free if they die, and then the tax bill kicks in once the second person in the couple dies.

I'll explain this a bit better. We'll talk about an imaginary couple. Let's have Dave and Marge, who seems to have quite a large head – sorry, Marge. So, let's pretend but between them they have a house that's worth £600,000 and they've also got savings – they've been saving very hard – of £600,000. So, their assets together are £1.2 million. Now, remember, they have both got these allowances. So, they can both pass on tax-free £325,000 and £175,000 of the house.

Now, let's pretend that Dave dies. Sorry, Dave. His allowance and assets pass to Marge. So, she then becomes able to pass on £1 million tax free. So, there's only £200,000 that has to be taxed. So, that gets the same treatment. 40% tax, which is £80,000. That goes to these people as well, sorry. But it leaves £120,000 plus the £1 million that can be passed on before any IHT.

So, it's not as bad as you think.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Holly Black  is Senior Editor,

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