How is inheritance tax calculated?
To establish how much inheritance tax is due on an individual’s estate, it is necessary to calculate the value of their 'chargeable estate’. This can be done in a number of simple steps:
add up all of the individual’s assets (e.g. property, savings, investments, etc);
deduct any liabilities they have (e.g. outstanding mortgage, loans, credit cards, etc);
deduct any exemptions that apply (e.g. spouse/civil partner exemption, gifts to charity, etc);
deduct any inheritance tax reliefs that apply (e.g. business property relief, agricultural property relief, etc); and
deduct any available nil rate band – i.e the tax-free threshold set by HMRC (remembering that any gifts in the seven years before death 'eat into' the nil rate band).
The figure you arrive at is the chargeable estate. Inheritance tax is due on the chargeable estate.
If you leave gifts to non-exempt beneficiaries (e.g. your children) ‘free of inheritance tax’ in your Will, the inheritance tax due on the gift will need to be paid out of your estate.
If you leave a gift in your Will that is to be shared between exempt beneficiaries (e.g. a charity or charities) and non-exempt beneficiaries (e.g. nephews and nieces), you need to decide how the inheritance tax is to be dealt with. You can either choose for:
each share of the gift to be equal in size once any inheritance tax has been paid on the non-exempt beneficiaries’ shares; or
each share to bear its own inheritance tax (if any).
The first option may mean there is more inheritance tax to pay overall as the non-exempt beneficiaries’ shares will need to be ‘grossed up’, so that after payment of inheritance tax each beneficiary receives the same amount. However, the second option may result in the non-exempt beneficiaries receiving less than the exempt beneficiaries. Your Will needs to specifically state how you wish the gift to be structured.
What is the Current rate of Inheritance Tax?
0% on the tax-free allowance (which consists of the nil rate band - currently £325,000 – and the residence nil rate band - currently £175,000)
40% above the tax-free allowance unless you have included a charitable legacy within your Will and can apply a reduced rate of 36% in that instance.
Example 1
If your estate is valued at £1,000,000 (including your main home), and you die during the financial year 2022-2023 with your full nil rate band available, leaving the whole of your estate to your children for instance, inheritance tax will be charged at a rate of 40%.
In particular, on the chargeable estate which in this case is £500,000.
(£1,000,000 less £325,000 less £175,000 = £500,000. £1,000,000 less the exemptions totalling £500,000 = £500,000 and that is the chargeable estate)
40% of £500,000 (the chargeable estate) is £200,000. This means that £200,000 of inheritance tax will be due.
But if you make any gifts in the seven years before you die, these will be offset against your available nil rate band.
Example 2
Your estate is valued at £1,000,000 as above; and you make gifts of £250,000 in the seven years before your death.
In this case, the available nil rate band is reduced by the value of the gifts. So, £325,000 plus £175,000 = £500,000. But we need to reduce the total amount by the value of the gifts i.e. £250,000, so the available allowance decreases from £500,000 to £250,000. This means that inheritance tax at a rate of 40% will be charged on £750,000, (£1,000,000 less £250,000) resulting in £300,000 of inheritance tax being due.
Charitable Legacy and the rate of Inheritance Tax
The rate of inheritance tax may be reduced to 36% if you leave 10% or more of your net estate to charity. Your net estate is your total assets less all debts, liabilities, reliefs, exemptions (e.g. anything left to your spouse or civil partner) and your available nil rate band.
There are a number of exemptions and reliefs that can reduce the amount of inheritance tax you pay. If a gift is exempt from inheritance tax (such as gifts to a spouse or civil partner) it means that there is no inheritance tax to pay. A relief from inheritance tax usually applies to a specific type of property (such as agricultural property or business property).
Depending on certain criteria, the rate of the relief can be 50% or 100%:
A gift of an unquoted shareholding attracts 100% business property relief so there would be no inheritance tax to pay. Unquoted shares are ones that are not traded on any stock exchange.
A gift of a quoted shareholding attracts 50% business property relief so inheritance tax would be payable but at half the usual rate. Quoted shares are ones that are traded on a stock exchange.
Inheritance tax rate for lifetime gifts
Some gifts you make during your lifetime are immediately chargeable to inheritance tax. These include:
gifts to relevant property trusts (e.g. a discretionary trust);
gifts to companies;
gifts by close companies (i.e. companies with five or fewer participants, or any number of participants if they are directors, who have control of the company or who together have the right to receive more than half of the assets if the company is wound up); and
an alteration of share capital by close companies.
The rate of inheritance tax for chargeable lifetime gifts is 20% (as opposed to 40% on death). A nil rate band is still available (currently £325,000), and replenishes itself every seven years.