It's known colloquially as the death tax, and for good reason.
Inheritance tax - the bane of modern life - dates back to 1894 when the Government introduced estate duty (a tax on the capital value of land) in a bid to raise money to pay off a multi-million pound deficit. Its 21st century incarnation includes a tax on property, money and other assets of someone who has passed away.
The thing about inheritance tax (IHT) is this: no one really understands it, and the complexity is not helped by the Government's constant tinkering around the edges. Put simply, everyone has a tax-free allowance, known as the ‘nil rate band’. The tax-free threshold for the current 2016-17 tax year is £325,000 where it has been since 2009.
Married couples and civil partners can pass their estate or the unused balance of the tax-free allowance to their spouse tax-free when they die so the surviving partner can double the threshold before IHT becomes payable to £650,000.
Impact of house prices
However, because of rising house prices, and to a lesser extent rising share values, there has been criticism that when someone leaves their mortgage-free home as part of their estate, in many parts of the country this is enough to make them liable for IHT.
It is a lucrative tax for government. Official figures show receipts of £4.7 billion IHT in the year to April 2016, a bumper annual rise of 22 per cent.
What was designed as a tax on the relatively wealthy now affects middle-income earners. Having followed the advice of a range of governments since the Second World War and saved to pay off their mortgage before they retire, now when they die, rather than passing on the family home to their children tax-free, their dependants are likely to face a hefty tax bill.
There are ways to combat IHT which have been widely used by the richer parts of society the tax was initially aimed at, but less so by the ordinary homeowner increasingly drawn into the IHT net.
The new rules
In an effort to reduce the impact of IHT on middle-income families, in July 2015’s Summer Budget, then Chancellor George Osborne announced that from 6 April 2017, each person will receive an extra £100,000 on their IHT allowance rising to £175,000 by 2020-21, solely to be used against the value of their home that forms part of the estate to be left to children, stepchildren or grandchildren.
For single people with the same dependants, the limits are £325,000 and a further £175,000 specifically for property that is part of their estate.
The allowance can be transferred to a surviving spouse or civil partner if unused. So, by 2020-21, even if the basic rate of IHT remains at £325,000, if both allowances were passed to a surviving spouse, a married couple could leave £1 million to their children without incurring IHT.
How to reduce IHT liability
As well as passing on your allowance to your spouse, there are other tax-mitigating strategies to consider.
One option is to pay into a pension that pays your spouse on your death rather than into a savings account, or you could put assets in trust for heirs. Leaving a legacy to charity can also reduce your IHT bill.
Certain gifts and property are exempt. These include wedding gifts and agricultural property. Gifts of up to £3,000 a year can be passed to beneficiaries but they are subject to IHT if given seven years or less before the benefactor dies. The amount of tax due depends on the value of the gift, who it’s for and when it was given.
IHT is charged at 40 per cent. For someone leaving an estate of £500,000 this year, before the new rules apply, £175,000 would be taxable at 40 per cent, creating a tax bill of £70,000. This is normally payable by the executor of the will unless the deceased has left money in the estate to pay the bill or has a life insurance policy in place to cover it.
Once IHT is paid, the residue of the estate can be distributed to the beneficiaries. If at least 10 per cent of the estate is left to charity, the entire bill becomes liable for IHT at a reduced rate of 36 per cent. IHT is payable within six months of the person’s death.
Using a life insurance policy to pay IHT can be tax-efficient and safeguard the family home from having to be sold to pay the bill. But the policy must be written in trust before the benefactor dies. There can be tax implications in doing this so check first.
There are normally two types of policy for this purpose. A whole of life policy lasts as long as you live and pays out only when you die. A term policy covers a specified length of time and only pays out if you die within that time.
Tax planning is complicated so make sure to seek advice from a qualified financial adviser.
Ben Salisbury is Online News Editor at WhatHouse?