How much is inheritance tax and how is it calculated?

Inheritance tax (IHT) is a tax on someone’s estate when they pass away. It applies only to the portion of an estate that's above a certain cut off.

But how much is inheritance tax and how is inheritance tax calculated?

Figuring out how much you owe can be confusing to say the least. But we’re here to put it in plain terms so you can confidently do the sums and have a better understanding of how much you or your loved ones will have to cough up in inheritance tax.

What is the inheritance tax threshold?

The standard rate is currently 40% on anything above the nil-rate band. Basically, any value over the threshold gets taxed at 40%.

For the 2023/24 tax year, the nil-rate band is £325,000 per person. That means the first £325,000 of an estate is immune from inheritance tax when someone dies. For married couples and civil partners, the nil-rate band doubles to £650,000. Any unused allowance carries over to the surviving partner's estate too.

All makes sense so far, right? The tricky part is often trying to put a value on the things that make up the estate - you might have old jewellery tucked away in a drawer that carries some value, but how much exactly is anyone’s guess!

What assets are included in valuing an estate?

• Property – This includes any homes, land or buildings owned by the deceased at the time of death. The value is based on market value less any outstanding mortgages.
• Money – This covers any cash the deceased had in bank accounts or savings at death, including ISAs.
• Investments – The estate includes stocks and shares, premium bonds, cryptocurrency or other investments held.
• Household goods – Furniture, art, jewellery, cars and other possessions are all included at estimated market value.
• Pensions – Some pensions pass outside of the estate but others are included subject to certain rules.
• Trusts – Assets held in trust where the deceased had an interest are subject to inheritance tax.
• Life insurance payouts –These may form part of the estate depending on who they are paid to.

Certain other assets are exempt from inheritance tax, including business or agricultural property receiving 100% or 50% relief.

You add up the total asset values to get the gross estate value.

From there, you subtract any debts owed and other liabilities - mortgages, loans, bills, funeral costs, etc. Charitable gifts in the will also reduce the value. What's left is the net estate value, which inheritance tax applies to.

Allowances and exemptions

Beyond the nil-rate band, there are other allowances that can reduce an estate's inheritance tax liability:

• Annual gift allowance – £3,000 per tax year can be gifted by an individual exempt from inheritance tax. Any unused annual allowance can be carried forward one year.
• Small gift allowance – Gifts under £250 per person per tax year are typically tax-free.
• Marriage gifts – £5,000 can be gifted tax-free to a child getting married, £2,500 to a grandchild, and £1,000 to anyone else.
• Gifts to a spouse – All gifts between UK spouses are exempt from inheritance tax, no matter their value.
• Charity exemption – Gifts to registered charities reduce the taxable estate.

With proper planning and some shrewd decision making, you can make use of these allowances to reduce inheritance tax exposure. It's also possible to take out insurance policies specifically to cover potential inheritance tax costs.

How is inheritance tax calculated?

Once the total net estate value is determined, the inheritance tax liability is calculated by deducting any available nil-rate band and subtracting gifts exempt from tax.

For example, let’s say an estate is worth £500,000 after debts and exemptions. The nil-rate band covers the first £325,000, so this leaves £175,000 of the estate above the threshold. Inheritance tax of 40% would be due on that £175,000, meaning £70,000 tax is owed.

For married couples, calculating inheritance tax on the second death is more complex due to transferring unused allowances and the residence nil-rate band.

Always seek professional advice so that you don’t flunk the figures!