How does inheritance tax in the UK work?

inheritance tax

You’ve heard it a million times. Benjamin Franklin’s over-cited quote that “Nothing in this world is certain, except death and taxes” has a ring to it. If death and taxes are both unpleasant certainties, you’d imagine the combination of the two – inheritance tax – would be the worst of all. But it turns out that with proper planning, there are several ways to minimise your tax bill.

Let’s have a look at how it works and what can be done about it.

The basics of inheritance tax:

  • The UK Inheritance tax rate is 40% and it is paid on the part of your estate that exceeds £325,000.
    It has to be paid within only 6 months of death. In the case of property or other illiquid assets, you can pay in 10 yearly instalments, but you will incur a 3% interest rate.
  • Gifts of more than £3,000 per year, given up to 7 years before death, to anyone other than your spouse, are taxable at rates that start at 8% and increase to 40% depending on the year. There is no tax if you live more than 7 years after the gift has been made.
  • There are exemptions for Businesses, except for those that are primarily investment companies, whether in financial assets or real estate.
  • If you pass away abroad but lived in the UK at any time in the 3 years prior to death, or for 17 of the 20 years prior to your death, you are subject to tax on all your estate both in- and outside the country. Otherwise, you are only subject to tax on the portion that is in the UK, with some exclusions, including holdings in unit trusts and OEICs and foreign currency accounts.
  • You don’t have to pay income tax, capital gains tax or stamp duty on what you receive as an inheritance. But you do have to pay tax on income or capital gains that you make after it is yours.
  • A new tax-free ‘main residence’ band will be introduced from 2017, but it is only valid on a main residence and where the recipient of a home is a direct descendant. It is being phased in gradually, starting at £100,000 from April 2017, rising by £25,000 each year till it reaches £175,000 in 2020.

Inheritance tax in perspective

First, let’s put the inheritance tax threshold of £325,000 into perspective: The median average UK salary is currently £27,531, so the threshold is nearly over twelve years of average income. On the other hand, it doesn’t even come close to the average London house price – now over £500,000.

Let’s say your parents own a property worth £1.5 million, and investments worth £500,000 when they pass away. The tax bill would be £670,000. In other words, you would have to liquidate all the investments and on top of that either sell the house or put in £170,000 of your own to keep it. Ouch!

What you can do about inheritance tax

Retire abroad and take your assets with you. The rules on overseas assets are strict – you need to have lived outside the UK for 18 of the past 20 years. But if you are planning your retirement, with life expectancies as long as they are, you could still work your entire life in the UK, retire at 60 and leave a nice tax-free inheritance in a low-tax jurisdiction at or after the age of 78. And if you are going to keep a place in the UK to visit, remember – rent, rather than buy. Even in this case your UK assets are subject to tax.

Give as much of your assets as you can to your children. Sure, if you die between 3 and 7 years after the gifts, your estate will still have to pay some inheritance tax, but at lower rates than the full 40%. Of course, there are some rules designed to prevent people from giving away all their assets and still benefiting from them and their income, so it is important to talk to an expert to make sure you are on the right side of the law.

Buy a business. As long as you have owned the business for 2 years prior to death, it is completely exempt from inheritance tax. Of course, it can’t be a business that is set up just to hold property or financial assets, and obviously any small to mid-sized business will involve higher risks, less liquidity and require more attention than those kinds of assets. But if your heirs are interested in owning their own businesses, it could be an excellent, if unconventional, solution.

Utilise a Trust. When you deposit money or property in a trust, you don’t own it any longer so it may not count towards your Inheritance Tax bill. There are several different kinds of trust many of which you can set up right now.

Some trusts will have to pay Inheritance Tax in their own right rather than as part of your tax bill; others might have to pay Income Tax or Capital Gains Tax. The kind of trust you choose depends on what you want it to do. Here are some of the most common options:

  • Bare trust – the simplest kind of trust, a bare trust just gives everything to the beneficiary straight away (as long as they’re over 18).
  • Life interest trust – the beneficiary can receive an income straight away, but doesn’t have a right to the cash, property or investments that generate that income.
  • Discretionary trust – the trustees have absolute power to decide how the assets in the trust are distributed. You could set up this kind of trust for your grandchildren and leave it to the trustees (who could be the grandchildren’s parents) to decide how to divide the income and capital between the grandchildren. The trustees will have the power to make investment decisions on behalf of the trust.
  • Trust for a vulnerable person – if the only one who benefits from the trust is a vulnerable person (for example, someone with a disability or an orphaned child) then there’s usually less tax to pay on income and profits from the trust.
  • Non-resident trust – a trust where all the trustees are resident outside the UK. This can sometimes mean the trustees pay no tax or a reduced amount of tax on income from the trust.

Because tax laws are complicated and change over time, and because an inheritance involves a large sum of money being transferred, it is important that you do things right. The last thing you want is to be hit with a surprise tax bill because your reading of the law was not quite right. So it is important to consult tax lawyers or financial advisors on the best way to manage your inheritance tax exposure. But fortunately, with some foresight, there are legal ways to minimise how much your estate will have to pay.


Chris has 9 years’ experience as a UK pension specialist and licensed financial advisor. He specialises in helping clients make balanced financial decisions to grow their personal wealth.

Chris is licensed with Holborn Assets, an award-winning international financial advisory firm established in 1999, with 10 offices and 15,000 clients worldwide.



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