The UK’s tax system is one of the most complicated in the world.
Inheritance tax is currently at a rate of 40% and generally applies when an estate is worth more than £325,000.
Inheritance tax is only paid on the amount that exceeds the limit and should be paid within six months of the death.
There are many ways inheritance tax liability can be reduced (such as the trust-based will); we’ve set out some of the most relevant below.
The family home
The most commonly relevant exemption is the ‘residential nil-rate band’.
Where the family home (meaning a property the deceased has lived in at some point since owning it) is being transferred to a direct descendent, £175,000 more is allowed to be transferred tax-free.
So, where the family home is being passed on to a direct descendant, the threshold becomes £500,000 (the standard £325,000 + £175,000).
This applies when the total estate is worth less than £2 million.
There is generally no inheritance tax due on inheritance left to a spouse.
However, when the spouse is not based in the UK, there is a limit of £650,000 on transfers (nil-rate band of £325,000 + £325,000 spousal exemption).
A non-domiciled spouse can elect to change their domicile to the UK (as a ‘lifetime election’ or, if on the death of the UK-based spouse, ‘death election’) so that they can enjoy transfers free from inheritance tax from the domiciled spouse. In doing so, the surviving spouse will have elected to have their entire estate, including any overseas assets, subject to the UK inheritance tax.
The election ceases to have effect on non-UK assets once the individual has resided outside of the UK for more than three consecutive tax years following the date of the death. Where the surviving spouse leaves the UK for at least four tax years then they will be considered based abroad again and non-UK assets will cease to be liable to UK inheritance tax.
Where someone does not use their whole £325,000 nil-rate allowance, their spouse can claim it to increase their own nil-rate allowance by the percentage of that was left unused. As such, Wills should request that executors report how much of the nil-rate band has been used to the surviving spouse once everything is settled.
Gifts to charities and national institutions are exempt for inheritance tax.
If 10% of an estate is given to charity then the inheritance tax rate becomes 36% rather than 40%. This does not ultimately save money but it can inform your decision of how much to give to charity.
Not only can giving gifts in your lifetime minimise your inheritance tax liability, you can also give as you please as the sharia inheritance allocations do not apply until your death.
There are many inheritance tax rules that can apply to lifetime gifts, here are the ones you most need to be aware of.
£250 can be given to any person tax-free – with a limit of £3,000 in total for the year (so that’s 12 £250 gifts). If this £3,000 limit is not fully used one year, it can be carried over (but only to the next year).
Gifts can also be made tax-free if ‘in consideration of marriage’. There are a few rules for this:
- The gift must be made on or soon before the official wedding date.
- The wedding has to be completed.
- £5,000 max can be given tax-free if you are a parent.
- £2,500 max can be given tax-free if you are a grandparent.
- £1,000 max can be given tax-free from anyone else.
Notwithstanding the above, gifts made within seven years of the date of death are generally subject to inheritance tax (though after 3 years the inheritance tax rate reduces with every additional year that passes). Such gifts are known as ‘Potentially Exempt Transfers’.
Normal expenditure out of income
There is a huge exception you should be aware of – the exception for ‘normal expenditure out of income’.
Income (wage, pension etc.) can be given away as a gift with no limit. This is so long as the gift is made on a ‘regular’ basis (e.g. Eid, birthdays) and does not affect the giver’s standard of living.
The Office of Tax Simplification stated that there are cases where over £1million is given away tax-free within a year using this exception.
For those who want to their businesses to be passed down their family, the ‘business property relief’ allows for passing it on tax-free if the business property has been held for two years or more. This can also apply to some investments in AIM-listed companies.
If you're around the inheritance tax threshold, it's worth familiarising yourself with the tax-minimising options we've made available for you that are set out here.
This article is part of our Islamic Wills FAQ series.