How is Inheritance Tax calculated and what grieving families NEED to know about the levy

Inheritance tax is widely abhorred by the public. It is a tax on death, property and the natural desire to pass on wealth from generation to generation.

If this bugs you, there are two very important things to keep in mind regarding estate taxes.

First, only the wealthiest 4 percent of families pay it. Second, if that applies to you, there are many ways to plan ahead and help your loved ones avoid the charge.

That said, the 40 percent inheritance rate is drastically high if you’ve accumulated enough assets that your beneficiaries can be held liable for a portion of them.

And the trends are moving in the wrong direction for wealthy taxpayers, especially those who own a home in a price hotspot.

The real estate boom of recent decades plus frozen thresholds has dragged many more grieving families into the inheritance tax net, and the Treasury is raking in ever larger amounts as a result.

The amount raised in April and May rose 9.1 per cent year-on-year to £1.2 billion, according to the latest HMRC figures.

So how much is inheritance tax, how does it work, and what are the best ways to protect your family from paying it.

How much is inheritance tax and who pays?

You must be worth £325,000 if you’re single, or £650,000 jointly if you’re married or in a civil partnership, for your loved ones to pay death benefits.

But there’s another hefty grant that raises the threshold to a joint £1 million if you have a partner, own a property and plan to leave money to your direct descendants.

Once an estate reaches £2 million, this homeownership allowance is deducted by £1 for every £2 above this threshold. It disappears completely at £2.3 million

If you’re worth more, your beneficiaries must relinquish 40 percent of your assets above that level to the government.

People who inherit property in the most popular house prices, often through work or family ties rather than by choice, tend to win the largest sums.

“A tax of 40 per cent is typically levied on a deceased person’s assets worth more than £325,000, which is called the zero rate band,” explains Heather Rogers, This is Money’s tax columnist.

“Many people are allowed to leave a further £175,000 worth of assets without becoming subject to inheritance tax, if their home forms part of their estate and they leave it to direct descendants.

This extra amount is the so-called zero-rate bracket and can be claimed in the event of death on or after April 6, 2017.

“That means children, including adopted, stepchildren or foster children, and the linear descendants of those children.

“Both protected amounts or ‘bands’, of up to £500,000 per person, can be transferred to a surviving spouse or civil partner if they are not used on the death of the first spouse.”

The thresholds explained above are frozen until April 2028, which means that more people’s estates will become subject to inheritance tax.

When do you have to pay?

Your heirs must pay inheritance tax at the end of the sixth month after your death.

And the tax must be paid before the executors of your estate receive probate, giving them access to and control over your money.

Rogers explains how to find the money here to pay estate taxes up front or pay in installments – although interest is charged.

Common solutions are a specialist loan or pre-arranged insurance.

How do you avoid inheritance tax?

Fortunately, there are many legal ways to dodge the dreaded 40 percent “death tax” if you want to pass on the maximum amount and plan ahead.

But you shouldn’t lie awake — much less work on elaborate avoidance tactics — unless you’re confident you’re wealthy enough to make it a problem for your family.

Meanwhile, financial advisors repeatedly remind people that the most cost-effective way to avoid estate taxes is to spend and enjoy your wealth or give it away early.

Here’s a rundown of ways to do this that can be easily accomplished by an ordinary person, or read our ‘Ten Tips to Legally Avoid Inheritance Tax’ for a full guide.

Gifts: You can give £3,000 a year, plus unlimited small gifts of £250, free of inheritance tax.

Wedding gifts are also exempt, although the amount depends on how close you are to the bride or groom. The limits are up to £5,000 for a child, £2,500 for a grand or great grandchild and £1,000 for anyone else.

You can give unlimited amounts to other people if you want, but they will fall under the so-called seven-year rule.

Officially, these are called “potentially exempt transfer gifts,” because if you survive seven years, the money is automatically exempt from inheritance tax.

If you die before the seven years are up, inheritance tax is levied on a sliding scale — starting at the full 40 percent hit if it’s within the first three years.

More income: You can also contribute to someone else’s living expenses – younger or older relatives, for example – but only if you can prove that it comes from additional income.

Such gifts must be made out of excess funds, which means your beneficiaries may need to show your old bank statements to HMRC to prove you didn’t need to spend that money on anything else.

Pension pots: You can pass on your retirement savings to your loved ones.

Currently, beneficiaries either pay no tax on inherited pensions up to the limit of the decedent’s lifetime benefit if the owner dies before age 75, or their normal income tax rate if they are 75 or older.

But beware, the Treasury is also apparently considering an income tax on retirement withdrawals inherited from younger savers, though there is uncertainty about how taking the pot as a lump sum can be treated.

Support a cause: You can donate or bequeath money to charities and political parties and it will be excluded from your estate when inheritance tax is calculated.

A political party must have succeeded in getting at least one Member of Parliament elected to Parliament in order to qualify for this exemption.

There is also a way to reduce your heirs’ inheritance tax rate from 40 percent to 36 percent of your taxable assets by donating to a charity, but not to a political party.

You can do this by leaving at least 10 percent of your net estate – the part that is subject to inheritance tax – to a good cause in your will.