How does the “7-year rule” of inheritance tax work to exempt donations

A third of Britons over 55 do not have specific plans for how they will pass their wealth on to friends or family after they pass away, although they do want to.

Research by Fidelity International also found that half of Britons were unaware or had never heard of the ‘seven-year rule’ of inheritance tax – although it could potentially exempt their citizens. beneficiaries of the levy.

The rule allows a donation of money, property or other assets to be exempt from inheritance tax (IHT) if the person offering it lives after seven years.

One-fifth of those intending to leave an inheritance worry about not understanding how much inheritance tax they might have to pay, or how to manage it effectively

This is a fundamental concept for anyone considering passing an estate on to the next generation, especially if their estate exceeds the current IHT threshold.

According to Fidelity, two-thirds of people aged 55 and over intend to leave a legacy with friends and family.

However, nearly a fifth of those intending to leave a legacy said they did not understand how much tax they might have to pay, and how to manage it effectively.

This is Money explains how inheritance tax works and what people need to know when considering how best to pass on their assets.

What are inheritance taxes levied on?

Inheritance tax is a tax on the estate of a deceased person, including their property, possessions and money.

It is typically charged at 40 percent on anything over the zero rate allocation bracket.

The standard zero rate range is £ 325,000 per person. However, there are several ways to increase your allowance.

First, any unused part of a deceased’s IHT allowance can be passed on to a spouse or civil partner, which can bring their limit up to £ 650,000.

Second, if a married couple or a PACS couple cedes their primary residence to their direct descendants, their limit is raised to a total of £ 500,000 each, or £ 1 million combined. This is called “the reduction of the principal residence”.

Confusion: According to Fidelity, nearly a fifth of people intending to leave an inheritance worried they might not understand how much tax they might have to pay

Confusion: According to Fidelity, nearly a fifth of people intending to leave an inheritance worried they might not understand how much tax they might have to pay

However, if the total value of an estate is worth £ 2million or more, the additional principal residence relief will be reduced to £ 1 for every £ 2 above the £ 2million threshold. .

This means that some higher value areas end up losing the edge altogether.

What is the typical heritage?

The average inheritance received in the UK is currently worth £ 70,639.

Even if someone left this amount for all of their four children, it would still be well below the limit of £ 325,000 for IHT.

But while tax is only paid by a small number of estates at present, the amount collected by the tax authorities has almost doubled in a decade, from £ 2.9 billion in 2011/12 to £ 5.33 billion in 2020/21.

In recent decades, more families have been caught in the inheritance tax net as rising house prices push more homes over the limit.

And with Chancellor Rishi Sunak freezing inheritance tax thresholds at current rates until 2026, that means more and more people will be dragged into paying tax.

Some analysts suggest that in the future, up to one in ten estates could end up paying 40% tax on some of the wealth they have passed on.

What does the seven-year rule apply to?

In most cases, the seven-year rule applies to all gifts that are greater than an individual’s annual grant allowance.

Usually this is £ 3,000 although if not used it can be renewed once giving them a limit of £ 6,000.

Years between gift and death Tax paid
Less than 3 40%
3 to 4 32%
4 to 5 24%
5 to 6 16%
6 to 7 8%
7 or more 0%

For the purposes of the IHT, donations in excess of these allowances are referred to as potentially exempt transfers.

If they do not exceed the person’s allowance of £ 325,000 at the time of death, nothing needs to be done.

But if the person exceeded this allowance at the time of death, the donation will only be exempt from inheritance tax if the person who made the donation survived more than seven years after making it.

If a person dies between three and seven years after making a donation, the inheritance tax due is gradually reduced.

For example, the tax burden drops from 40 to 32 percent if a person lives three years after making a donation, and from 32 to 24 percent if they survive four years.

Dawn Mealing, Head of Advisory Policy and Development at Fidelity International, said: “Our research points to a real problem with estate planning in that many people don’t know where to start.

Fidelity research also found that only 12% of people aged 55 and over had discussed estate planning with a financial advisor, and only three-fifths had made a will.

Fidelity research also found that only 12% of people aged 55 and over had discussed estate planning with a financial advisor, and only three-fifths had made a will.

“Consumers have said they think the rules and regulations are confusing, and it is concerning that a third of those nearing retirement have no concrete plan to pass their wealth on.

“Ultimately, that could mean they have a lot less to leave with their loved ones than they would like.”

Do all inheritances have to be declared to the tax authorities?

Fidelity’s research also suggested that many Britons might worry unnecessarily about the need to report inheritances they receive to HMRC.

So far, around 275,000 of the average 570,000 deaths per year have resulted in the submission of inheritance tax forms with the estate value declared to HMRC, even with no taxes payable.

This despite the fact that less than 25,000 bereaved families per year are subject to inheritance tax, which represents 5% of all deaths, according to the Office of Tax Simplification.

But new rules are coming from January 2022, which means that nine out of ten estates that are not subject to inheritance tax will no longer need to fill out the forms.

Fidelity found that up to 85% of people aged 55 or older were unaware of the new rules.

Taxation year Government estate tax receipts (billions of pounds sterling)
2011/12 £ 2.90 billion
2012/13 £ 3.11 billion
2013/14 £ 3.40 billion
2014/15 £ 3.80 billion
2015/16 £ 4.65 billion
2016/17 £ 4.82 billion
2017/18 £ 5.21 billion
2018/19 £ 5.36 billion
2019/20 £ 5.12 billion
2020/21 £ 5.33 billion
Source: mutual HMRC / NFU

How can you pay less?

If you’re worried about inheritance taxes, you might want to give gifts to your family while you’re alive rather than leaving everything in your will.

Not only does this offer tax benefits, but it also means you can see them enjoying their freebies while you’re still around.

You receive a gift allowance of £ 3,000 each year which falls immediately from your estate for inheritance tax purposes.

You can also make small gifts up to £ 250, specific gifts for family weddings and unlimited regular gifts from your income.

As for those who need to reduce or avoid a large inheritance tax bill, we have previously compiled an overview of ways to do so, some of which can be easily undertaken by any ordinary person without the need for convoluted arrangements or paying for professional help.

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