Nil rate band and tax rates

Introduction

Inheritance Tax (IHT) is levied on the estate—encompassing property, money, and possessions—of an individual who has died. It applies to both transfers made during a person's lifetime and those occurring upon death. Central to IHT calculations are the nil rate bands, specific tax rates, and the classification of different types of transfers under UK law. Accurate knowledge of these elements is required for determining tax liabilities and is fundamental to estate planning and tax law.

The Nil Rate Band in Inheritance Tax Planning

At the core of IHT calculations lies the Nil Rate Band (NRB), currently set at £325,000 until April 2026. This threshold represents the amount up to which an estate—or certain lifetime transfers—is not subject to IHT. Understanding how the NRB operates is essential for calculating potential tax liabilities arising from both lifetime gifts and transfers upon death.

Sequential Application of the NRB

When multiple transfers occur over time, the NRB is applied in a specific order, affecting the tax payable on each transfer. The NRB is first allocated to lifetime transfers made within seven years before death, such as Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs). Any remaining NRB is then applied to the estate upon death.

Example:

Consider an individual who makes the following transfers:

• 2014: Gift of £200,000
• 2016: Gift of £150,000
• 2019: Passes away, leaving an estate valued at £500,000

The NRB is applied sequentially:

1. 2014 Gift: The £200,000 gift uses £200,000 of the NRB, leaving £125,000 remaining (£325,000 - £200,000).
2. 2016 Gift: The £150,000 gift uses the remaining £125,000 of the NRB, with £25,000 not covered and potentially subject to IHT.
3. Estate on Death: With no NRB left, the entire £500,000 estate is subject to IHT.

Transferability Between Spouses

An important feature of the NRB is its transferability between spouses or civil partners. If the first spouse dies without using all of their NRB—perhaps because assets were left to the surviving spouse, which is typically exempt from IHT—the unused portion can be transferred to the survivor's estate. This effectively increases the NRB available to the surviving spouse's estate upon their death.

Illustration:

Consider a married couple where the first spouse dies and leaves all assets to the surviving spouse. Because transfers between spouses are exempt, the deceased's NRB remains unused. When the surviving spouse later passes away, their estate can benefit from both their own NRB and the transferred NRB from their late spouse, potentially reducing the IHT liability.

Potentially Exempt Transfers (PETs) and Lifetime Chargeable Transfers (LCTs)

Understanding the distinctions between different types of lifetime gifts is essential in IHT planning, as they are treated differently under the law.

Potentially Exempt Transfers (PETs)

PETs are gifts made during a person's lifetime to other individuals (not to trusts or companies) that become exempt from IHT if the donor survives for seven years after making the gift. If the donor dies within seven years, the gift becomes chargeable.

Key points about PETs:

• No Immediate IHT: There's no immediate tax when the gift is made.
• Becomes Chargeable if Donor Dies Within Seven Years: The value of the gift is brought back into the estate for IHT calculations.
• Uses NRB in Order: PETs consume the NRB in chronological order before the estate on death.

Lifetime Chargeable Transfers (LCTs)

LCTs primarily refer to gifts made to most types of trusts and some companies. They are immediately chargeable to IHT at the lifetime rate of 20% on amounts exceeding the available NRB.

Key points about LCTs:

• Immediate Charge to IHT: May incur a 20% IHT charge at the time of the transfer if they exceed the NRB.
• Additional Tax if Donor Dies Within Seven Years: An extra charge may apply, increasing the total IHT to the death rate of 40%.
• Affect NRB Availability: LCTs reduce the NRB available for subsequent transfers.

Interaction Between PETs and LCTs

When both PETs and LCTs occur within seven years before death, they interact in determining IHT liabilities, affecting how the NRB is allocated.

Scenario:

Suppose a person makes:

• 2015: LCT of £300,000 to a trust
• 2018: PET of £200,000 to a child
• 2020: Passes away

Calculations:

1. LCT Allocation: The £300,000 LCT uses £300,000 of the NRB, leaving £25,000 available (£325,000 - £300,000).
2. PET Becomes Chargeable: The PET of £200,000 is now chargeable because the donor died within seven years. Only £25,000 of NRB remains, so £175,000 (£200,000 - £25,000) is taxable.
3. Estate on Death: With the NRB exhausted, the entire estate is subject to IHT.

Taper Relief: Reducing IHT on Gifts Made Before Death

Taper Relief reduces the amount of IHT payable on gifts made between three and seven years before death. It's important to note that it doesn't reduce the value of the gift itself but reduces the tax payable on it.

How Taper Relief Works

The reduction is based on the number of years between the gift and the donor's death:

• 3-4 years before death: 20% reduction
• 4-5 years: 40% reduction
• 5-6 years: 60% reduction
• 6-7 years: 80% reduction

Taper Relief applies only to the amount of IHT payable, not to the value of the gift.

Example:

An individual makes a PET of £500,000 five and a half years before dying. The NRB has already been used.

1. Taxable Amount: £500,000
2. IHT at 40%: £200,000
3. Taper Relief at 60%: £120,000 reduction (60% of £200,000)
4. IHT Payable: £80,000 (£200,000 - £120,000)

The Residential Nil Rate Band (RNRB)

In addition to the standard NRB, the Residential Nil Rate Band (RNRB) provides an extra allowance when a residence is passed to direct descendants.

Key Features of the RNRB

• Amount: Up to £175,000 (as of the 2021/22 tax year).
• Eligibility: Applies when the home is left to direct descendants like children or grandchildren.
• Estate Value Threshold: The RNRB tapers away for estates valued over £2 million, reducing by £1 for every £2 above this threshold.
• Transferability: Unused RNRB can be transferred to a surviving spouse or civil partner.

Utilizing the RNRB Effectively

Maximizing the benefit of the RNRB involves careful planning:

• Ensure Direct Descendant Inheritance: The property must be left to direct descendants.
• Manage Estate Value: Reducing the estate's value below £2 million preserves the full RNRB.
• Downsizing Provisions: If the main residence is sold or downsized, provisions exist to retain the RNRB, provided certain conditions are met.

Example:

An individual has an estate worth £2.3 million, including a residence valued at £700,000. Because the estate exceeds £2 million, the RNRB begins to taper. In this case:

• Amount Over Threshold: £300,000
• RNRB Reduction: £150,000 (£300,000 ÷ 2)
• Available RNRB: £25,000 (£175,000 - £150,000)

By gifting assets during their lifetime to reduce the estate below £2 million, the individual could retain the full RNRB, potentially saving up to £70,000 in IHT (40% of £175,000).

Estate Planning Strategies

Effective estate planning aims to minimize IHT liability while ensuring that assets are distributed according to the individual's wishes.

Making Use of Exemptions and Reliefs

Several exemptions can reduce IHT liability:

• Annual Exemption: Gifts up to £3,000 per year are exempt.
• Small Gifts Exemption: Gifts of up to £250 to any number of individuals are exempt.
• Normal Expenditure Out of Income: Regular gifts from surplus income may be exempt if they don't affect the donor's standard of living.

Utilizing Trusts

Trusts can help manage and protect assets, potentially reducing IHT:

• Discretionary Trusts: Allow flexibility in distributing assets but may have immediate IHT implications if they exceed the NRB.
• Interest in Possession Trusts: Provide income to a beneficiary during their lifetime, with the capital passing to others upon their death.

Considering International Aspects

For individuals with international connections, additional factors come into play:

• Domicile and Residence: These affect how IHT applies to worldwide assets.
• Double Taxation Treaties: Can provide relief when IHT is chargeable in multiple countries.

Conclusion

Calculating Inheritance Tax involves complex interactions between various principles. Starting with the application of the nil rate band (NRB) and the residential nil rate band (RNRB), it's essential to understand how potential exempt transfers (PETs) and lifetime chargeable transfers (LCTs) impact the overall tax liability. Taper Relief adds another layer, reducing IHT on gifts made several years before death.

These concepts interact in significant ways. For instance, the sequential application of the NRB affects how much tax is payable on multiple transfers, and the interplay between PETs and LCTs can complicate calculations. Precise knowledge of these elements is necessary for accurate tax assessments and effective estate management.

By comprehending how these principles work together, one can calculate tax liabilities accurately and manage estates in accordance with legal requirements.