IHT - your most popular questions answered

Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

2. Can you use a life insurance policy to cover a failed gift?

If you’re worried about dying within seven years of making a gift and landing your estate with a large IHT bill, you can take out a life insurance policy written in trust to cover the potential IHT liability.

The policy pays out a lump sum on death, which can be used to settle the IHT bill. Because the policy is held in trust, the payout would not form part of your estate and should be available immediately, without waiting for probate.

This means your estate will have ready cash available to cover any IHT bill without being forced to sell assets. You could tailor the policy to match the value of the gift and the potential tax bill.

However, the cost of premiums for a policy like this can be significant, especially for older individuals or those with health issues.

It’s important to structure the policy appropriately and to hold it in trust to avoid adding to the value of the estate. This is where taking qualified financial advice would be very valuable.

3. Are the £325,000 nil-rate band and £175,000 main residence nil-rate band treated separately in the assessment of any IHT liability, or are they merged to a total of £500,000 per person?

This is a common question. A lot of people take the “up to £500,000” headline allowance at face value and assume they will be able to pass on the maximum. However, the £500,000 maximum that individuals can pass on IHT-free is in fact made up of two separate allowances.

You can pass on up to £325,000 (known as the nil-rate band) to anyone IHT-free. You can also pass on up to £175,000 extra (the main residence nil rate band) so long as you are passing on a main residence to your direct descendants, e.g. children or grandchildren. But you can only claim the main residence nil rate band up to the value of your property: if your property is worth less than £175,000, you won’t get the full allowance.

Say, for example, someone wanted to pass on £400,000 of savings and investments and a £100,000 property to their children - a total estate value of £500,000. They would be able to use the full nil rate band (£325,000) but they would only be able to claim £100,000 of the £175,000 main residence nil rate band because of the value of their property.

Therefore, the total amount they can pass onto their children IHT-free is £425,000 and IHT will be charged on the remaining £75,000 of the estate. The rate of IHT is currently 40% - giving an IHT bill of £30,000.

Remember that if you're married or in a civil partnership, any unused nil-rate bands can usually be transferred to the surviving spouse, potentially allowing up to £1 million to be passed on IHT-free.

Does this mean, then, that people who downsize or sell their home in later life get penalised and lose their main residence nil rate band?

Not quite. You may still be able to use your allowance if you qualify for what’s called a “downsizing addition”.

You can claim this if:

• the person sold, gave away or downsized to a less valuable home, on or after 8 July 2015
• the former home would have qualified for the main residence nil-rate band if they’d kept it until they died
• their direct descendants inherit at least some of the estate

With the downsizing addition, the main residence nil rate band will usually be the same as if the former home was still in the estate.

Remember that if the value of your estate is more than £2m, you start to lose the main residence nil rate band and, once the estate is worth more than £2.35m, you lose it entirely.

4. Once IHT has been paid on an estate, does the beneficiary then pay income tax on the amount they receive?

Beneficiaries do not pay income tax on the inheritance itself once IHT has been paid by the estate. However, they may be liable for other taxes depending on what they do with the inherited assets.

For example, if you inherit a property which you rent out, you could be liable for income tax on the rental income. Equally, if you receive income via dividends (outside of an ISA), savings, or from a trust, then this will be taxed at your marginal rate of income tax.

Capital gains tax (CGT) should not be due when you inherit an asset. However, if you later sell that asset and it has increased in value since you inherited it, then CGT will apply.

Beneficiaries get a “step-up in basis”: this means you do not pay CGT on gains made before you inherited the asset. Instead, the asset’s value is reset to its market value at the date of death. Remember: CGT does not apply to investments held within an ISA.

5. What are the benefits of trusts in saving IHT?

Trusts can be a useful way to manage your estate for IHT purposes. You can use trusts to control how and when your beneficiaries receive the assets, to protect them from future claims (e.g. divorce settlements or creditors), and to give you flexibility. For example, you could set up a trust that pays you any investment income but preserves the capital for someone else.

However, trusts are not a guaranteed way of reducing your IHT liability.

Whether or not IHT will be due depends on when the trust is created, what type of trust it is, and how assets are transferred in or out.

For discretionary trusts (the most common type), IHT may be payable:

1. When assets are transferred into a trust

• If the value of assets transferred into a trust exceeds the nil-rate band (£325,000), a 20% lifetime IHT charge may apply immediately.

2. On the 10-year anniversary of the trust

• Every 10 years, trusts may face a periodic charge of up to 6% on the value of assets above the nil-rate band.

3. When assets are distributed

• When assets are distributed from a trust, an exit charge may apply, calculated based on how long the assets were held and their value.

4. On death

• If the donor dies within 7 years of setting up the trust, additional IHT at 40% may apply, minus any tax already paid, depending on the type of trust and whether the transfer was a chargeable lifetime transfer.

Some other types of trusts, such as bare trusts or those for vulnerable beneficiaries, may be treated more favourably for IHT purposes.

Trusts are an extremely complex area where careful structuring is very important. It would likely be beneficial to speak to a financial adviser.

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• Read: Autumn Budget: inheritance tax and other possible changes
• Read: How could the inheritance tax seven-year rule change?
• Read: 5 IHT mistakes that could cost you thousands