What is Inheritance Tax?

Inheritance tax (also known as IHT) is a significant worry for a growing number of people, and a subject for frequently passionate debate. As house prices have risen the number of people affected by IHT has grown, making it a widely held concern. But what is inheritance tax, and how does it affect you?

IHT is a tax that is levied not on your earnings, as is the case for income tax, but on the value of an individual's assets upon their death. It was initially devised as a method of breaking up large estates, but now frequently affects those who were not its initial targets.

IHT is levied on what is known as the 'estate' of the deceased; the estate is comprised of all of the assets under the ownership of the deceased. The estate does not, however, include what (if anything) is owed by the individual; debts are repaid before the estate is calculated.

Nil-Rate Band

Some estates are exempt from inheritance tax. IHT is only payable if the total value of the estate falls above a certain benchmark, known as the nil-rate band. This amount rises every year, roughly in line with inflation. The nil-rate band is currently set at £325,000. If the total value of the deceased individual's estate is greater than the nil-rate band then IHT will be payable only on the excess, and not on the value of the entire estate. If the estate is valued at less than this rate, no IHT will be payable at all.

Estates that are liable for IHT will have the tax levied at a flat rate of 40% on the excess above the nil-rate band. The liability must be paid from the estate by the executor or administrator (they are known as an administrator only if the deceased individual failed to nominate an executor in their will) within six months of the end of the month in which the individual in question died.

Exemptions

There are, however, a number of IHT exemptions. Perhaps most importantly, any assets that are transferred directly from the estate of a deceased individual to their surviving spouse or civil partner will not have IHT levied, regardless of the value of that estate. Furthermore, it is possible to 'gift away' assets without incurring the tax; gifts made less than seven years before the death of the individual, but totalling less than £3,000, are exempt, as are almost all gifts made before this seven year period.

It is possible to use trusts to mitigate an inheritance tax liability. This is achieved by the settlor legally divorcing themselves from all or some of their assets. As they are no longer a part of the individual's estate, the beneficiaries are not required to pay the tax. It should be noted, however, that an IHT charge at the regular rate is immediately levied on transfers of assets that exceed the nil-rate band, thus making it a potentially ineffective course of action in some circumstances. This is investigated in more detail in another article in this section.