What is inheritance tax
Inheritance Tax is the tax applicable on the estate of a deceased individual. This is calculated once a probate valuation of the estate of the deceased has been carried out.
Inheritance Tax: New Rules
There is a new set of laws regarding Inheritance Tax that have taken effect. As a result of these new rules, a vast amount of homes will become exempt from being liable for inheritance tax. However one can avail these rules only if they satisfy the conditions that come with them.
An estate is exempt from inheritance tax if it is valued at £325,000 or less. If the value exceeds this, then the amount on which Inheritance Tax will be calculated is the differential between the total value and the tax exemption limit (e.g. if the estate is valued at £400,000, then the tax will be calculated on £75,000 (£400,000 – £325,000)). Now every individual is entitled to an added allowance of £100,000 in that limit. This extra allowance is to increase to £175,000 in 2020. This means that an estate of £1 million can now be exempted from tax for a couple.
Not everybody may be entitled to this though. For example a couple that is childless would not qualify for this. Neither do a lot of business owners. Estates that are valued at £2 million may not be exempted as well.
Advisers are saying that people need to revisit their wills in view of the new circumstances. If they have been planned keeping in mind old tax structures, they could possibly backfire. According to Ian Dyall, who is the chief of estate planning at Tilney (an advising firm), traditional estate arrangement plans are now ineffective and need to be reviewed.
Experts advise that, given that a greater portion of a family estate will be tax exempt, seniors should carefully examine tax effective methods of saving their income for retirement purposes, if they want maximum benefit for the next generation.
The new rules are complex with many measures built in to thwart attempted evasion.
The working behind Inheritance Tax: old rules
As of before, married individuals could give all of their assets to their other halves without being taxed. Tax would have had to be paid in the event of passing wealth to the next generations. £325,000 (also known as residence nil rate band ‘RNRB’) could have been passed on without being liable for tax calculation. Spouses could have also passed on the RNRB to each other.
According to Danny Cox (chartered financial planner at the investment company Hargreaves Lansdown), if the wife were to pass away first and left her husband everything, he could have given away £650,000 without being taxed. The government would have taken 40% of the remainder.
Wife using part of her allowance
The wife could have given any allowance that had not been used, as a portion of the RNRB at the time of her death. The rate is subject to change as time passes. When the husband dies, that portion will be calculated against the then current RNRB rate and could be used to reduce the tax on his estate.
What has changed?
The additional allowance of £100,000 per individual will increase to £125,000 by 2018, £150,000 by 2019 and £175,000 by 2020.
Spouses can still pass this on to each other. This could potentially mean that they can pass on up to £1 million without having to pay tax.
The extra allowance can only be availed if the inheritors of the estate are children, grandchildren, adopted children or stepchildren. This means that the allowance will not be applicable if the inheritors are nephews or nieces or siblings.
If the estate has been left to somebody in trust, the allowance will not apply. Therefore, wills need to be reviewed.
According to Ian Dyall, it was common practice for a spouse to leave their part of the estate, up till the prevailing limit, in trust for the next generation. However this will not qualify now, because it is a trust that is a beneficiary.
What qualifies as a residence
In order to qualify for the residence nil rate band, the person has to leave in their estate, a property that was used as the primary residence for some time. Therefore properties that are buy-to-let do not qualify.
If an individual sells the current residence to move into a property that is smaller in size, a nursing home or on rent, the qualification for the RNRB will still remain.
This works in the following way. In the event of a sale of property after July 8, 2015, an individual can calculate the portion of claimable RNRB if he/she dies after April 2017 and had been living at the sold property. The added allowance can be utilized to decrease inheritance tax upon death.
Can wealth be given away before dying to avoid tax?
It is possible to give away wealth in the form of small gifts. That would be tax free. Larger assets can also be given away and not be part of an individual’s estate, if the individual survives for seven years after gifting away those assets.
Avoiding the £2m hurdle
Estates valued at more than £2 million will not qualify for the new RNRB.
People that are not “wealthy” could come under this as well. For example the wife might inherit her dead husband’s estate, which was valued at £1 million. If, at the time of her death, her entire estate (inclusive of what the husband left her) is worth £3 million, she would not qualify for the RNRB.
Why business owners could miss out
Business owners especially run the risk of losing out on the new RNRB. Business ownership can be passed down generations free of Inheritance Tax as businesses qualify for a benefit known as Business Property Relief. Even so, the value of the business is part of the estate value for the purpose of the RNRB, which then goes above £2 million.
According to Danny Cox, it is better to review one’s assets now to protect them from being taxed. The new regime allows for a greater allowance of the primary property to be tax free. Even pensions can now be passed on, exempted from tax. On the other hand, ISA portfolios are considered part of the estate for the purpose of Inheritance Tax. However spouses can pass on ISAs free of tax.
Author – Jeffrey Avery