Are You Wealthy Enough to Pay Inheritance Tax? How It Works and the Chances of a Budget Raid

Only the richest four percent of families pay inheritance tax, but many fear they could be sucked into its net, especially if the budget pushes for wealth.

Although the vast majority of estates are not affected, it is still regularly referred to as Britain’s most hated tax.

And the government is collecting ever higher amounts, because the thresholds for inheritance tax have been frozen and house prices are rising. As a result, the estates of more and more survivors are being taxed.

Latest figures from HMRC show that estates paid out £3.5bn between April and August this year, up £0.3bn on the same period in 2023.

Although 4.4 per cent of estates paid inheritance tax in 2021/22 – or 28,000 out of a total of 634,000 – receipts rose to a record £6 billion.

How do you calculate whether your family will have to pay inheritance tax under the current rules, and what impact could any changes the government makes to the budget on 30 October have on you? We explain below.

How much is IHT and who pays?

In the event of death, 40 percent inheritance tax is levied on assets above two important thresholds.

To determine the size of an estate, you must add together the value of all property (minus mortgages), investments, savings, and other assets.

You must be worth £325,000 if you are single, or £650,000 jointly if you are married or in a civil partnership, for your loved ones to have to pay inheritance tax. This is called the zero-rate band.

But there is a further exemption of £175,000 individual exemption if you are worth more than this and leave your own home to your direct descendants. This is the tax-free allowance for residential properties.

The maximum threshold increases to a joint amount of £1 million if you have a partner and own your own home.

Once an estate reaches £2 million, this ‘home ownership’ allowance is reduced by £1 for every £2 above this threshold. At £2.3 million it disappears completely.

Heather Rogers, tax columnist at Money, explains: ‘Many people are allowed to leave an additional £175,000 of assets without having to pay inheritance tax, if their home is part of their estate and they leave it to direct descendants.

‘That means children, including adopted, step or foster children, and the linear descendants of those children.

‘This additional amount is the so-called exemption for the mortgage debt. You can claim this in the event of death on or after 6 April 2017.

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

Heather Rogers has responded to many readers’ questions about inheritance tax – see below.

“Inheritance tax casts a long shadow,” says Sarah Coles, head of personal finance at Hargreaves Lansdown.

‘Millions of people are worried about the impact this tax could have on their families. Rumours of possible changes to the October budget have fuelled fears about inheritance tax.

‘Even those who fall well short of the current thresholds are concerned that changes to this tax could result in the tax authorities seizing a large portion of their estate after their death.’

What could happen to the IHT in the budget?

Increase in the inheritance tax rate by 40 percent

Coles said: ‘Less than one in 20 estates pay it, so it wouldn’t raise much money. If you hit the rich hard, they’ll pay for expert help to reduce their bill, so it could reduce the gains even further.’

Changing the zero-rate bands

People without children who leave their estate elsewhere, such as to other family members such as brothers and sisters or nephews and nieces, are not covered by the exemption scheme.

If the government no longer wants to punish the childless, it could introduce the home loan exemption for them too, or abolish the exemption and increase the exemption to £500,000 for everyone.

But it could abolish that threshold and bring the threshold for everyone to £325,000, or to a new level between that amount and £500,000.

Levying inheritance tax on pensions

Beneficiaries pay no tax on inherited defined contribution pension funds up to the deceased’s lifetime exemption limit if the owner dies before age 75, or their normal income tax rate if they are 75 or older.

The previous government also considered levying income tax on pension withdrawals from younger savers, but ultimately abandoned the idea.

According to Coles, the change will not affect people who use their pension to purchase an annuity, have a defined benefit pension or plan to spend their pension within their lifetime.

‘It will mainly affect people with larger estates who do not spend their pensions, because they die earlier than expected or because they have used their pensions to reduce their inheritance tax.’

> What could happen to pensions in the budget?

Rules for spouses and married partners

“Anything you leave to your spouse or registered partner is exempt from inheritance tax. And if you leave everything to them after your death, your tax-free margins will also be exceeded,” Coles said.

‘This means that when the second person in a couple dies, he or she can leave behind up to £1 million in assets tax-free.’

Amendment of the agricultural and commercial real estate tax

These tax benefits mainly benefit the very richest. Before using them to reduce inheritance tax, you should consult a financial advisor.

The government may want to tighten the rules in this area, but it does not want this to be at the expense of the owners of family businesses and smaller family businesses.

Furthermore, discouraging entrepreneurship or providing financing for start-ups would run counter to the mission of promoting economic growth.

How to avoid inheritance tax

Sarah Coles from Hargreaves Lansdown discusses some options.

– If you are worried that the government will reduce the tax-free allowance, you can give away up to £3,000 before the change. This will then fall within your annual gift allowance.

– You can give away larger amounts and these will fall outside your estate after seven years. There is a separate rule that means you can also give away surplus income tax-free.

– If you have children under 18, you could consider putting £3,000 into a Junior Isa for them each year.

You can pay up to £9,000 into a Junior Isa each year, but some of this will not expire from your estate until after seven years.

– If you invest in qualifying AIM companies and plan to take advantage of the inheritance tax exemption, this is not necessarily a signal to sell.

If the government were to completely abolish the tax cut, it would mean that taxes would be levied retroactively, which could seriously harm investment in smaller, listed companies.

It means that it can consider alternatives, such as changing the qualification period. If the investment is otherwise good for your portfolio, it doesn’t make sense to rush into a decision to sell.

– If you are concerned about the treatment of capital gains tax on death, it is a good idea to realise capital gains each year if possible and transfer as many assets as possible into stocks and shares ISAs during your lifetime, using the Shares & Shares ISA (Bed & Isa) process.

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