How Does Inheritance Tax Work in the UK?
Understanding how inheritance tax works is crucial for families looking to preserve their wealth and make informed decisions about estate planning. Inheritance tax (IHT) is a levy on the estate of someone who has passed away, and it can significantly affect what beneficiaries receive. In this article, we explain how inheritance tax works in the UK, who pays it, how to reduce liability, and the steps you can take to plan ahead.
To protect your estate and reduce your tax liability, you can book a free consultation with our estate planning experts or check our transparent pricing to get started.
What Is Inheritance Tax?
Inheritance tax is charged on the value of a deceased person’s estate, which includes their money, property, and possessions. In the UK, the standard inheritance tax rate is 40% on the portion of the estate above the nil-rate band (currently £325,000).
There are some exemptions and allowances that can reduce or eliminate the inheritance tax bill. For example, assets left to a spouse or civil partner are generally exempt, and additional allowances may apply when passing a home to direct descendants.
How Does Inheritance Tax Work in Practice?
The process begins after someone passes away. The executor or administrator of the estate assesses the total value of all assets and debts. Once calculated, HMRC determines whether inheritance tax is due.
Step-by-Step Breakdown of How Inheritance Tax Works
- Calculate the value of the deceased’s estate.
- Deduct any debts and liabilities.
- Subtract the available tax-free allowance (nil-rate band).
- Apply reliefs or exemptions if applicable (e.g., spouse exemption).
- Calculate inheritance tax at 40% on the remaining balance.
- Submit required forms to HMRC and pay the tax due before assets are distributed.
Visit the official UK government site for additional resources.
Inheritance Tax Allowances and Thresholds
To better understand how inheritance tax works, it helps to look at the available allowances:
- Nil-Rate Band: The first £325,000 of the estate is tax-free.
- Residence Nil-Rate Band: An additional £175,000 allowance is available when a home is passed to children or grandchildren.
- Spouse Exemption: Anything left to a spouse or civil partner is exempt from IHT.
- Charity Exemption: Gifts to UK-registered charities are also exempt from tax.
If unused, some allowances can be transferred between spouses, effectively doubling the tax-free threshold for married couples.
How Gifts Affect Inheritance Tax
Gifts made during one’s lifetime can affect how inheritance tax is calculated after death. This is a crucial aspect when exploring how inheritance tax works.
Key Gift Rules
- Gifts made more than 7 years before death are usually exempt.
- Gifts within 7 years may be taxed on a sliding scale (taper relief).
- Annual exemptions of £3,000 per year apply, plus small gift exemptions of £250.
Proper gifting can reduce the size of your taxable estate, but it’s important to structure gifts correctly. Speak with a professional to avoid mistakes.
Strategies to Reduce Inheritance Tax Liability
One of the most common questions people ask is: how does inheritance tax work when planning ahead? There are several strategies to reduce liability:
Use of Trusts
Placing assets into trusts can remove them from your estate for tax purposes, provided certain conditions are met. Trusts must be set up carefully to be effective.
Learn more about using trusts and tax planning at our Inheritance Tax Planning page.
Make Charitable Donations
If 10% or more of your estate is left to charity, the inheritance tax rate may drop from 40% to 36%—providing a generous and tax-efficient outcome.
Utilise Pensions
Pensions typically fall outside your estate for inheritance tax purposes. Passing on pension wealth can be more tax-efficient than other assets.
Take Out Life Insurance
Life insurance written in trust can help your family pay inheritance tax without needing to sell assets quickly.
Who Pays Inheritance Tax?
The responsibility for paying inheritance tax typically falls to the executor of the estate. In cases where the tax is due on gifts, the recipient may be responsible if the estate cannot cover the bill.
Beneficiaries do not usually pay tax on their inheritance, but they should be aware of the potential tax implications on income or capital gains from inherited assets.
How Does Inheritance Tax Work With Property?
Property is often the most valuable part of an estate and plays a big role in determining whether inheritance tax is due. The combination of the nil-rate band and residence nil-rate band can shield up to £500,000 of the value of a main residence—£1 million for couples.
However, if your total estate exceeds £2 million, the residence nil-rate band is gradually tapered away.
Want to safeguard your family home? Book a consultation today to explore your options.
Common Misconceptions About Inheritance Tax
Despite how common it is, many people misunderstand how inheritance tax works. Here are a few myths:
- “Only the wealthy pay inheritance tax.” – Many estates exceed the threshold due to rising property values.
- “You can give everything away before you die.” – Gifts within 7 years can still be taxed.
- “Pensions are always tax-free.” – While not subject to IHT, pension withdrawals may be subject to income tax.
Start Planning Early
Good planning is the best defence against a large inheritance tax bill. With the right strategy, you can protect your estate and reduce stress for your loved ones.
MP Estate Planning UK® offers expert guidance in crafting inheritance tax plans tailored to your family’s needs. Visit our pricing page to see our fixed-fee services or book your free consultation today.
Conclusion
Knowing how inheritance tax works is key to protecting your legacy. By understanding thresholds, exemptions, and strategic planning methods, you can significantly reduce your family’s future tax burden. Don’t wait until it’s too late—start planning now and safeguard what matters most.