What Is Inheritance Tax and How Does It Work?

In addition to being a relatively controversial concept, inheritance tax (IHT) is increasingly lucrative to the UK Treasury.

To this end, IHT receipts totalled an impressive £5.32 billion in the financial year 2020/21, although this was down slightly from the £5.32 billion recorded during the previous 12 months.

But what exactly is inheritance tax, and how does it work? Here’s a breakdown to help you on your way!

What Are The Different Types of Inheritance Tax?

In simple terms, IHT is the levy applied to the beneficiary of a will or estate, which must be paid in line with the amount inherited and the nature of the gift in question.

This term is often used interchangeably with estate tax, which is a similar levy that’s applied directly to the estate of the benefactor and charged prior to the wealth being distributed.

These terms are each integral to the concept of estate planning, which is a diverse and often complex entity that ensures an individual’s assets and responsibilities are passed in accordance with their wishes.

This is often governed by an independent will and administered by an executor who may be objective or a member of the bereaved family.

The Percentage of Tax and How IHT Works

After a will is administered and the benefactor’s assets are distributed, beneficiaries tend to receive a post-tax amount that can be used and invested as they wish.

This is because the income received has usually already been taxed before it reaches your account, with the levy applied to the deceased individual’s estate directly as part of the administration process.

But how much can you expect to pay? Well, the good news is that there’s usually no IHT due if the total value of a deceased’s estate is below the £325,000 threshold, which is classed as a nil rate band that also enables individuals to make lifetime chargeable transfers up to this value within a seven-year period without incurring such a liability.

Your estate may avoid the spectre of IHT if you leave everything above the £325,000 threshold to your spouse, civil partner or a charity of your choice, or in some instances a community amateur sports club.

There’s also a second, similar residence nil rate band up to £175,000, which doesn’t require any IHT to be paid by the benefactor.

If the value of your estate is above £325,000 and you don’t leave the requisite assets to others as outlined above, the standard rate of IHT is 40% and applied at the point prior to a will being executed.

What are the Challenges of Inheritance Tax?

There’s no doubt that IHT is a complex topic, with a number of different forms required depending on the value of your estate.

For example, you’ll have to use the IHT205 form if the gross value of your estate is under £1 million and the majority of assets are transferred to a surviving partner.

Conversely, a IHT400 form is required if the value of your estate is over £325,000 and no assets are being transferred, while other documentation may be required depending on your precise circumstances.

On another note, recent legal developments and court cases have increased the risk of potential challenges to the “validity” of wills in the UK, based on certain grieving grounds. This will add to the practical and emotional complexity of estate planning and IHT, and it’s important to bear this in mind as a benefactor.