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What is Inheritance tax?
Before the introduction of the seven-year rule, we must give an introduction to the “Inheritance tax”.
Inheritance tax (IHT) is a tax liability on a dead person’s estate. This tax must be paid within six months of a person’s death. Inheritance tax is often called cumulative tax. Accounts of earlier ‘gifts’ are deemed while evaluating the amount of Inheritance tax. This tax is levied on the estate that has been received through inheritance or has been gifted by someone.
What is considered as ‘gifts’?
‘Gifts’ are referred to anything that has value. Her Majesty’s Revenue and Customs (HMRC) considers gifts as possession, money or property. HMRC also addresses anything that has a loss in its value.
For instance, if you sell a car at a lower value, the difference in the actual value and the sell value is evaluated as a ‘gift’. These gifts are specified as ‘potentially exempt transfers.’
What are the standard Inheritance tax rates?
The tax threshold, also known as the nil-band rate, is different for different groups. For individuals, the nil-band rate is £325,000. For married couples, the nil band rate is £175000 (along with the residence nil-band rate, i.e. RNBR) for each partner. Similarly, for civil partnerships, it is £175000.
No tax must be paid for amounts below or equal to the nil-band rate.
However, any amount above the tax threshold is subjected to specific inheritance tax rates. The standard tax rate is 40 per cent on the remaining amount. It is charged only on the balance amount above the nil-band rate.
For instance, if your estate values £1,000,000 and the nil band rate is £325,000, the inheritance tax will be 40 per cent of £675,000.
However, the standard charge rates are lowered down to 36 per cent if 10 per cent or more of your estate is given as charity.
Who is liable to pay the Inheritance tax?
You would need to pay the inheritance tax to HMRC if your estate is assessed above the nil-band rate. According to the seven-year rule, if someone dies before seven years of gifting the asset, the gift would be liable to IHR.
What is the seven-year rule?
Apart from certain ‘gifts’, the rest of the estate is defined as Chargeable Lifetime Transfer (CLT). Such gifts are liable to immediate 20 per cent Inheritance tax to be charged on it. If it is paid through a trust, the standard tax charge is 20 per cent, while if the payment is made through a settlor, it is 25 per cent.
The seven-year rule states that if someone lives for seven years after gifting you an asset, the gift will not be subjected to any Inheritance tax.
However, if someone dies within seven-year of gifting an asset, the gift will be subjected to the Inheritance tax. Hence it will be counted during the evaluation of the tax threshold. But after seven years, it would not be counted in estimating your nil-band rate.
This rule is referred to as the seven-year rule in Inheritance tax.
What are Inheritance tax-free gifts?
A specific range of gifts is exempted from the Inheritance tax. Usually, if someone dies within seven years of gifting an asset, the gift is subjected to a standard inheritance tax charge. However, there are certain gifts that are not liable to any charge even after someone is still living after giving them. These gifts include:
- Anything gifted to your spouse or civil partner who resides in the UK is exempted from Inheritance tax. In some cases, the gifts are exempted from IHR, even for a non-resident UK partner.
- Gifts that are handed out on certain occasions like birthdays or anniversaries do not incur Inheritance tax. These gifts also include life insurance policy premiums or any other regular payments. As long as those gifts do not affect your regular income or it has been gifted from your regular income, they are not subjected to Inheritance tax.
- Gifts made to your family members or ex-civil partner or a child to help them with their living expenses or assist in the maintenance of family do not incur any inheritance tax on them.
- Wedding gifts worth £2500 to a grandchild or £1000 to someone else are not liable to inheritance tax.
- Gifts, irrespective of their value given as a charity to any university or a museum etc., are free from inheritance tax. There is no maximum value for gifts given as charities.
- Gifts were made to any political party. However, any two members of that political party must be elected to the House of Commons, or the member must be elected in the general elections with at least 150,000 votes.
Moreover, gifts worth £3000 can be gifted without any inheritance tax levied on them. However, gifts worth more than £3000 would incur an inheritance tax.
The unused annual exemption from the previous year could be carried over as well.
You are also allowed to give away an unlimited number of gifts worth £250 each throughout the year without any inheritance tax on them.
However, the same person cannot use the exemption for receiving gifts more than once a year.
The value of inheritance tax is estimated on the number of years of survival of the benefactor. It means that if the benefactor lives for more years, the inheritance tax charged would be lesser and vice-versa. ‘Taper relief’ is the term for this.
The taper relief came into existence under the Inheritance Tax Act 1984.
Here is a list of inheritance tax charges according to the survival period of the benefactor.
Period of Percentage of
survival tax reduced
- 0-3 years -0%
- 3-4 years -20%
- 4-5 years -40%
- 5-6 years -60%
- 6-7 years -80%
- 7+ years -100%
It must be noted that taper relief only applies to the balance above the tax threshold. It does not apply to the value of the gift. It means that the remaining estate will be charged at the standard inheritance tax rates.