Anticipating death is gloomy but making timely decisions about this inevitable turn of events is wise. One of the most confusing aspects of handling an estate is inheritance tax. If you don’t plan correctly, it may cost your loved ones hundreds of thousands of pounds after you pass away. There are ways to reduce the amount of inheritance tax owed. One method that people tend to overlook is applying the 7-year rule. Here, we define the 7-year rule in inheritance tax and discuss how inheritance tax planning might lower the amount of estate tax that you pay.
According to Opinium’s Research, most British adults over 55 want to leave their loved ones something once they pass away. Their analysis further says, just 50% of respondents are totally aware of the 7-year limit for inheritance tax.
You’ll probably leave your family or close friends with a lot of gifts once you pass away. If you’re leaving a cash bequest in your will, you need to understand whether it will cause a tax liability. To ensure that you can minimise any potential tax liabilities on your estate, it is crucial that you grasp the 7-year rule.
What is IHT?
It is crucial to first comprehend the ins and outs of inheritance tax before getting into the 7-year rule in inheritance tax. One can call a tax on the estate of a deceased individual as inheritance tax, or IHT. The onetime tax is due within six months of the decedent’s passing.
A deceased person’s property, belongings, and money make up their estate. You must determine if you owe inheritance tax after determining the estate’s value. Anything exceeding the nil-rate band allowance is subject to inheritance tax at a rate of 40%. The typical nil-rate band allowance per person is £325,000. This means that only the portion of the estate that is greater than this amount is subject to tax.
For example:
Your estate is worth £400,000. The tax-free threshold is £325,000.
The inheritance tax charged will be 40% of the difference, which is £75,000. In this scenario, the tax bill would be equal to £30,000.
One can pass any unused amount within the threshold onto a surviving spouse or civil partner. This might bring their nil-rate band up to £650,000.
This is besides the primary residence nil-rate band (RNRB). It is an extra nil-rate band for married couples or civil partners. It is applied when their estate includes a property that they leave to their children or other direct descendants.
The current level for residence nil-rate band sits at £175,000. This is an infamously complex area of law, and we would advise to get expert legal help to avoid any potential pitfalls.
What does the 7-year rule in inheritance tax mean?
The 7-year rule in inheritance tax applies specifically to gifts. In this context, “gifts” refers to things that have worth in general, such as belongings, money, and property rather than simply objects that you have wrapped in ribbon and paper.
While some gifts may be exempt from inheritance tax, the regulations apply to most of them.
Gifts that are taxable fall into two kinds. Gifts you make to discretionary trusts are chargeable lifetime transfers (CLT), which may cause an immediate inheritance tax levy of 20%.
The 7-year rule may apply to transfers that fall into the second category, known as potentially exempt transfers (PET).
If you live for 7 years after giving a PET to a person, the gift will be entirely tax-free.
The asset will count towards the value of your estate and the £325,000 allowance if you pass away within 7 years of gifting it.
The 7-year rule for inheritance tax states that a gift made after 7 years does not count towards the value of your estate.
The inheritance tax bracket is tapered on a sliding basis if you make a gift and pass away between three and seven years after transferring the item. The scale that specifies that is following:
This rule is why, very often, parents will give their children or grandchildren gifts long before they believe they will pass away, to avoid paying tax on the gift.
What is Taper Relief?
Taper relief is a crucial component of the 7-year rule for inheritance tax. In essence, taper relief kicks in if the beneficiary doesn’t live the full seven years. In other words, a sliding scale is used to determine how much inheritance tax is due if the beneficiary lived for at least three years. As you can see, giving gifts sooner rather than later is preferable.
| Number of Years Before Death | Taper Relief % | Tax Payable on Gifts Above Nil-band Rate |
|---|---|---|
|
0-3 years |
0% |
40% |
|
3-4 years |
20% |
32% |
|
4-5 years |
40% |
24% |
|
5-6 years |
60% |
16% |
|
6-7 years |
80% |
8% |
|
7+ years |
No tax |
0% |
Remember, taper relief only applies to the amount of tax the recipient must pay on the value of the gift that’s above the nil-rate band.
Example
For example, suppose Alpha gifted £600,000 to their son in May 2016. Alpha died in March 2021, having left their £1,200,000 estate to their son as well. Because Alpha died within 7 years of making the gift, it contributes towards their nil-rate band. IHT is due on the value of the gift above the nil-rate band (£600,000 – £325,000 = £275,000), but because Alpha died 4-5 years after making the gift, the amount of IHT their son is required to pay was reduced by 40%. So, the overall amount of inheritance tax that Alpha’s son needed to pay was £66,000 (£275,000 x 24% = £66,000).
Because the gift used up Alpha’s entire nil-rate band, their son will need to pay inheritance tax on the estate at the full 40% IHT rate as well. This means that the estate of Alpha had to pay £480,000 (£1,200,000 x 40% = £480,000) before the assets could be distributed.
This instance should have clarified your confusions regarding 7-year rule in inheritance tax.
Note:
There are separate rules around property, which means a higher nil-rate band is available for some, known as the residence nil-rate band. The residence nil-rate band is only applicable to direct decedents, so it’s important you understand the rules depending on who is receiving the gift, how the tax is applied to the gift and how these different rules apply to you.
Gifts that are tax-free
if you believe your estate is worth more than £325,000. Then it might be a good idea to start thinking. Think how to reduce the potential tax liability that your loved ones will have to cope with when you die.
Consider giving away assets while you are still alive as one of the easiest ways to avoid inheritance tax.
The tax-free presents you may consider are listed below:
- £0 – Tax paid when gifting to a spouse or civil partner, including when you die
- £0 – Tax paid on gifts given for the maintenance of old relatives
- £0 – Tax paid on gifts to charities or political parties
- £3,000 – Amount you can gift tax-free in a tax year, known as “annual exemption”
- £5,000 – Amount you can gift tax-free to your children for their wedding
- £250 – Amount you can gift tax-free to someone who hasn’t already benefited from your annual £3,000 exemption
- 18 – Maximum age you can gift your children with maintenance for their education tax-free
Firstly, even if it is within seven years of your passing, your civil partner or spouse will not be responsible for paying inheritance tax on any assets gifted to them.
This is so that your surviving partner receives a tax-free sum of your estate when you pass away.
A parent may give their child £5,000 tax-free as a wedding gift. On top of that, you have the permission to make tax-free donations to political organisations and charities.
Similarly, you may give up to £3,000 as an “annual exemption” in a single tax year. After this exemption, you may give a further £250 to anyone who didn’t receive the first $3,000 in benefits.
By using donations in this way, you might begin to lower your tax obligation and bring the total value closer to £325,000.
FAQS
What tax regulations does the government apply to investments that are inherited?
For federal tax reasons, whether you inherit money, investments, or property, the law does not regard inheritances as income. However, unless they come from a tax-free source, any further earnings on the inherited assets are subject to taxation.
How to apply the 7-year rule in inheritance tax in the UK?
If you stay alive for seven years after making a gift, you owe no tax on it, unless you made it as part of a trust. The seven-year rule refers to this. The amount of inheritance tax that must be paid after your death if you pass away within 7 years after making a gift and there is any leftover depends on when you made the gift.
What is the nil rate for inheritance tax in the UK?
IHT has a tax threshold known as the “nil rate band,” below which there is no tax due because the rate is zero percent. The fundamental threshold for 2023–2024 is £325,000. Anything exceeding this normally has a rate of 40%.
