Inheritance Tax and the Spouse Exemption Explained
Inheritance Tax
Inheritance Tax or ‘IHT’ as it is commonly known is a form of Tax that is triggered on a person’s death.
Will it affect me?
Long has it been assumed that IHT is the burden of the super wealthy, however with years of soaring house prices before the credit crunch more and more people are affected by IHT, with home-owners at the highest risk of future liability.
The Inheritance Tax Threshold
It is not however all doom and gloom because there is a relatively large exemption from IHT, known as the Nil Rate Band or IHT ‘threshold’. The threshold is the upper limit on the value of a persons estate at which IHT becomes payable.
Put simply - for the financial year 2007/2008 a persons estate must have exceeded £300,000 (the Nil Rate Band) before any IHT is payable in respect of it.
This high threshold, according to Inland Revenue figures, does mean that over 95% of estates are not affected by IHT, this percentage has however started to drop dramatically as house prices continued to rise.
Exceeding the Threshold
Although the IHT threshold initially seems to be set quite high, a glance at average house prices in England reveals just how easily the average home-owner can exceed the IHT threshold.
HM Land Registry reported that in April 2008 the average house price in the North West of England was £138,869, in the East Midlands it was £143,049 and in the South West it was £196,897.
When considering the average prices together with other everyday assets the following example demonstrates just how easily the IHT threshold can be reached and exceeded:
• House - £190,000
• Life Insurance Policy - £100,000
• Pension Lump Sum - £40,000
• Bank Accounts - £5000
• Car - £5000
• Total Value of Estate - £340,000
How Much Inheritance Tax will I have to pay?
Essentially the amount of IHT payable on a person’s estate is 40% of the amount of the estate which exceeds the IHT threshold.
Again using the earlier example we can see how this applies:
Total Value of Estate £340,000
Less
IHT Threshold £300,000
Equals
Total Estate liable to IHT £40,000
Total IHT payable £16,000 (40,000 at 40%)
The Spouse Exemption
Transfers of property and gifts between husband and wife, no matter how large in value, are exempt from Inheritance Tax. This is referred to as the spouse exemption.
It therefore follows that the simplest way to avoid paying any IHT is to leave all of ones estate to their spouse.
However affective a method of avoiding IHT the spousal exemption is, its poor application in some cases can render it a delay tactic rather than a complete solution.
In leaving all of ones property to their spouse the joint wealth of both spouses will accumulate to one spouse when the other dies. When the remaining spouse passes away IHT will be payable on the cumulative total of the two estates, which can, in some cases, lead to an increased IHT liability. Please see the example below for an example of how this can happen:
Example 1
- A has an estate worth £340,000.
- B has an estate worth £40,000
- A dies leaving the £340,000 to B.
- On A’s Death no IHT is payable.
- B now has an estate worth £380,000.
- B dies leaving everything to her son C.
- IHT is now payable on £80,000 at 40% = £32,000 IHT
As we can see from the example above, by leaving all of their estate to their spouse, A has wasted their Nil Rate Band allowance and an increased IHT Liability has been incurred.
If however A leaves a significant amount to C in the first instance IHT can be avoided completely, as can be seen from example 2 below:
Example 2
- A has an estate worth £340,000.
- B has an estate worth £40,000
- A dies leaving the £260,000 to B and £80,000 to C.
- On A’s Death no IHT is payable.
- B now has an estate worth £300,000.
- B dies leaving everything to her son C.
- No IHT is payable.
As can be seen, no IHT is payable on A’s death because the £260,000 to B is covered by the spouse exemption and the £80,000 to C is below the IHT threshold.
There is also no IHT payable on B’s death because B’s estate falls below the IHT threshold.
This offers a simple but effective solution to the problem of IHT.
Conclusion
Used correctly and in conjunction, the spouse exemption and the Nil Rate Band can offer a complete solution to a persons IHT liability, but used poorly the IHT liability of spouses can be increased.
There are many factors which can affect a persons liability to IHT, all of which need to be considered in conjunction when IHT planning or when a person’s IHT liability is being calculated, this article is merely a brief overview of what is a very complicated area of law and an isolated look at one of the many IHT exemptions, this article is not intended to be a comprehensive guide and we recommend that the advice of a professional is always sought when IHT planning.
For further information or for a no obligation interview please contact Andrew Marsden on 0161 876 2588 or andrew.marsden@colemans-ctts.co.uk