Certainty number 1: death
For some, ensuring a will is in place is a natural consideration. It affords peace of mind that, when we pass away, our possessions and money are given to the people we care about and can be particularly valuable in the event of estranged families, as the intestacy rules could result in undesirable family members inheriting. The desire to have a will in place is also often triggered by a significant life event: marriage, divorce, children, illness, a milestone birthday or a windfall of cash.
However, the complexity of will drafting is often underestimated. Whilst it may seem a simple concept to just give away belongings or money to friends and family, doing so in an inefficient or careless way can trigger significant tax bills against the estate, leaving beneficiaries with a smaller slice of the pie than we intended.
Certainty number 2: (Inheritance) tax
When we die, our estate becomes taxable by way of IHT which is applied at a rate of 40%. The extent and rate at which the estate value is calculated and IHT payable depends on a multitude of factors, including the availability of any relief or exemptions.
Spouse exemption
Spouse exemption affords surviving spouses the benefit of inheriting their deceased spouse’s estate, entirely tax free. There is no limit to the value of an estate that can be passed on tax-free to a spouse.
This exemption is available to married couples only and not to co-habiting partners, irrespective of how long they have been together.
The nil-rate band and the residence nil-rate band
Much like income tax, estates are entitled to hold assets up to a certain value before IHT becomes payable. This is called the nil-rate band (‘NRB’) which is (currently) £325,000. This means the first £325,000 of a deceased person’s estate is taxed at the date of death at 0%.
In the case of married couples, both spouses have a NRB. If all, or any part of the NRB of the first spouse is unused on their death, then it is available to be transferred (called the transferable nil rate band or ‘TNRB’) against the estate of the second spouse on their death.
Therefore, the second spouse to die may have a combined NRB of £650,000 at today’s rates. Unmarried couples or singletons can only use their own NRB.
An additional tax allowance is the residence nil-rate band (‘RNRB’) and is available to individuals who leave a residential property to “direct descendants” (spouses, children or grand-children). Provided that the qualifying conditions are met, each person is entitled to £175,000 or the value of the property – whichever is lower.
As with the NRB, married couples can carry forward and use any unused RNRB of the first spouse to die and set against the estate of the surviving spouse on their death.
Collectively then this means that (for married couples) the estate of the second spouse to die could potentially benefit from a maximum allowance of £1m. For unmarried couples and singletons, the maximum allowance is £500,000.
Using the NRB before we die: lifetime gifts
Whilst the above reliefs are available to everyone (except for spouse exemption which is available only to married couples), it does not follow that we will be able to utilise the full amount as default. It is possible for the NRB to be used before we die, meaning our estates do not see the full benefit of the allowance/s.
Oftentimes, this is done by people (either knowingly or unknowingly) making what are known as lifetime gifts. Although making a gift does not automatically reduce our NRB, there are conditions the gifts must meet in order to avoid adverse tax consequences. Any gifts that do not meet these conditions will be considered failed gifts and will be held against our estate when we die.
Potentially Exempt Transfers
Lifetime gifts (i.e gifts made while we are still alive, but excluding gifts into trust) are known as ‘potentially exempt transfers’ (‘PETs’). If a donor dies within 7 years of making the gift, the value is set against the estate for IHT purposes either by reducing the NRB or increasing the IHT payable. If IHT is payable, it is reduced on a sliding scale once the donor survives the gift by 3 years.
These can take the form of, but are not limited to, cash gifts: selling a property to someone at a discount (e.g for £100,000 when the property is worth £150,000) is considered a PET, the value being the difference between the property market value and what you sold it for i.e £50,000.
Any PET (cash or otherwise) that is made and then not survived by the requisite 7 years is considered a failed gift and is read back to the estate on death. The full value of the failed gift can be reduced either by having survived the gift for 3 or more years but less than 7, or by offsetting any unused annual exemption allowance (explained below) against the value of the PET.
Annual Exemption (Section 19 of the Inheritance Tax Act)
Each tax year, every person is entitled to gift £3,000 without being classed as a PET – this is called the Annual Exemption (‘AE’). This can be made up of one lump sum to one person, multiple sums to one person, or multiple sums to multiple people. The main takeaway is that the limit is capped at £3,000 (subject to any carry over – see below).
Any unused allowance in a tax year can be carried forward for one year only. For every £3,000 you give away, you could save £1,200 in IHT.
For example (illustrating both PETs and AEs):
- you make a single cash gift of £2,000 in tax year 2020/2021;
- you can carry forward the unused £1,000 of into tax year 2021/2022, giving a total combined exemption of £4,000 for that tax year;
- you then make a gift of £10,000 (a PET) in tax year 2021/2022, but die 6 months later;
- the unused annual exemption of £4,000 can be used to offset against the failed PET, meaning either:
- the NRB is reduced by £6,000 (instead of £10,000); or
- if the NRB has already been used in full by the estate, the estate will be liable to pay tax at 40% on £6,000
Small Gifts Exemption (Section 20 of the Inheritance Tax Act)
It is possible to make small gifts of £250 to any number of individuals each tax year, provided those individuals did not already receive any of the £3,000 referred to above.
Normal Expenditure Out of Income (Section 21 of the Inheritance Tax Act)
This can be a useful tool if you want to make regular payments to an individual (for example, to grandchildren).
The gifts can be of any amount but there must be prior commitment to make the gifts, or it must be shown that the gifts were part of a settled pattern of giving.
The gifts must also be made out of surplus income, so it is necessary to show that you have enough income to make the gifts and still maintain your standard of living.
‘Income’ does not only include pensions, but all interests and dividends.
How do I know which option is best for me?
Ultimately, IHT is an optional tax, insomuch as that it can be legitimately mitigated by taking steps while we are alive. However, doing so is not a box ticking exercise and requires an element of being tactical and a comprehensive understanding of what we can and cannot do with our assets and money while we are alive.
Private client solicitors are very much alive to IHT and how easy it is to be caught out by failed gifts or poor estate planning. It is therefore important to be transparent with your solicitor about the value and extent of your assets, so that they can identify any potential tax consequences and advise on what options are available to you.
In the instance of significant wealth, or where you own a variety of assets, it may also be appropriate to approach an independent financial advisor not only from an IHT perspective, but also in relation to income tax, capital gains tax, business property relief and pension planning.
If you are concerned about tax consequences after you are gone or are seeking general advice in relation to estate planning either in conjunction with an independent financial advisor or for legal advice only (and not financial advice), you can call us on 03456 465 465 and make an enquiry with our expert private client team.
Disclaimer: This blog is for information only and does not constitute legal advice. If you need legal advice please contact us on 03456 465 465 or email enquiries@rotherabray.co.uk to get tailored advice specific to your circumstances from our qualified lawyers
