Welcome to the World of Inheritance Tax!

Hello there! Today, we are diving into one of the most important parts of the UK tax system: Inheritance Tax (IHT). Specifically, we’re looking at how tax is calculated when someone gives away assets during their life or passes them on after they die.

Don't worry if this seems a bit heavy at first. Think of IHT as a way the government takes a small "slice of the pie" when wealth moves from one person to another. We will break this down step-by-step so you can master these calculations with confidence!

1. The Big Picture: When does IHT happen?

In the eyes of the taxman, there are three main times wealth is taxed:

  1. Chargeable Lifetime Transfers (CLTs): These are usually gifts made into trusts. Tax might be due immediately at the lifetime rate.
  2. Potentially Exempt Transfers (PETs): These are gifts made from one individual to another individual. They are "potentially" exempt because if the donor lives for 7 years, no tax is ever paid!
  3. The Death Estate: This is the net value of everything a person owns on the day they pass away.
Quick Review: The "Seven-Year Rule"

If you make a gift and survive 7 years, that gift falls out of the death tax calculation. If you die within 7 years of making a transfer, it becomes chargeable on death, and earlier gifts within that 7-year window consume your available Nil Rate Band first.

2. Chargeable Lifetime Transfers (CLTs)

When someone puts money into a trust, it’s a CLT. Unlike gifts to individuals, these can trigger a tax bill right away.

How to calculate the Lifetime Tax:

1. Start with the Value of the Gift (the donor's diminution in value).
2. Subtract any Exemptions (like the £3,000 Annual Exemption).
3. Check the Nil Rate Band (NRB) of £325,000. Under the seven-year accumulation principle, the NRB available is reduced by any other CLTs made in the 7 years prior to this gift.
4. Calculate the lifetime tax on the excess over the available NRB.

The Two Tax Rates for CLTs:

  • 20% if the Trustee (the recipient) pays the tax.
  • 25% if the Donor pays the tax. This grossing-up reflects that paying the tax is itself a further loss to the donor ( rac{20}{80} = 25%).

Example: If Ben transfers £400,000 to a trust and has already fully used his NRB on earlier CLTs, and the trustees pay the tax, the lifetime tax is:
\( £400,000 \times 20\% = £80,000 \)

Key Takeaway: CLTs are the only lifetime gifts that can trigger immediate tax. Always check who pays the tax to decide between 20% and 25%.

3. The Death Tax Calculation

When someone dies, we look back at the gifts made in the 7 years before death and then compute the tax on the death estate.

Step 1: Re-evaluating Lifetime Gifts (PETs and CLTs)

Lifetime transfers made within 7 years of death are taxed at the Death Rate of 40%, allocated against the full £325,000 NRB in chronological order:

  • Failed PETs: Taxed at 40% on the excess over the available NRB at death.
  • CLTs within 7 years: Recalculated at the 40% death rate using the NRB available at the date of death.

Step 2: Taper Relief and Lifetime Tax Credit

If the donor survived at least 3 years after making the gift, the death tax liability is reduced by Taper Relief:

  • 0–3 years: 0% reduction (100% tax payable)
  • 3–4 years: 20% reduction (80% tax payable)
  • 4–5 years: 40% reduction (60% tax payable)
  • 5–6 years: 60% reduction (40% tax payable)
  • 6–7 years: 80% reduction (20% tax payable)

Crucial Rule for CLTs: After applying taper relief, any lifetime tax already paid is deducted as a credit. Only the remaining excess is payable on death. If the lifetime tax paid exceeds the death tax, the additional liability is £0; HMRC never pays a refund.

Step 3: Calculating the Death Estate

Finally, we assess what the individual owned on death:
\( \text{Assets} - \text{Debts and Funeral Expenses} - \text{Exemptions} = \text{Chargeable Estate} \)

The Death Estate is taxed at 40% on everything above the remaining Nil Rate Band (after subtracting gifts made in the 7 years before death) and any available Residence Nil Rate Band.

Common Mistake to Avoid: Remember that only chargeable transfers made within the 7 years before death reduce the £325,000 NRB available to the death estate. Earlier transfers made more than 7 years before death do not reduce the death estate's NRB!

4. Important Exemptions

Not everything is taxed! Here are the core exemptions you must know:

  • Spouse/Civil Partner Exemption: Gifts between legal spouses or civil partners are 100% exempt, whether made during life or on death.
  • Annual Exemption (AE): Every individual has an annual exemption of £3,000 per tax year. Any unused AE carries forward for one year only, used after the current year's £3,000 allowance.
  • Small Gifts Exemption: Outright gifts of up to £250 per person per tax year are completely exempt (cannot be combined with other exemptions on the same person).
  • Gifts in Consideration of Marriage: Up to £5,000 from a parent, £2,500 from a grandparent, or £1,000 from anyone else.
  • Normal Expenditure out of Income: Regular gifts paid out of surplus income that leave the donor with enough income to maintain their normal standard of living.

5. Nil Rate Bands: Transferable NRB and RNRB

To reduce tax on death, two further rules are tested:

  • Transfer of Unused NRB: If a deceased spouse or civil partner did not use 100% of their £325,000 NRB, the unused percentage can be claimed by the surviving spouse on their death, providing up to an additional £325,000 (total maximum £650,000).
  • Residence Nil Rate Band (RNRB): An extra allowance of up to £175,000 applies when a residential property is left to direct descendants (children, grandchildren). Any unused RNRB from a spouse can also be transferred. The RNRB applies only to the death estate, never to lifetime gifts.

Summary Formula for Death Tax on the Estate:
\( (\text{Chargeable Estate} - \text{Remaining NRB} - \text{RNRB}) \times 40\% = \text{Tax Due} \)

6. Summary and Final Tips

The IHT Pro-Plan:
  1. List transfers in strict chronological order.
  2. Apply Exemptions: Deduct marriage exemptions, then current year and brought-forward Annual Exemptions (£3,000).
  3. Calculate Lifetime Tax on CLTs: Apply the available NRB (looking back 7 years from the gift) and tax the excess at 20% (trustee pays) or 25% (donor pays).
  4. Calculate Death Tax on 7-year Gifts: Look back 7 years from death, allocate the £325,000 NRB chronologically, apply the 40% death rate, deduct Taper Relief, and deduct lifetime tax paid on CLTs.
  5. Calculate Death Estate: Net assets minus remaining NRB and RNRB, taxed at 40%.

Key Takeaway: IHT is all about the order of events and distinguishing the 7-year lookback for lifetime transfers from the 7-year lookback from death. Master the chronology, and you will ace these questions!