Full Breakdown of Inheritance Tax Essentials

Many people find the rules surrounding inheritance tax confusing, especially when it comes to calculating how much needs to be paid.

Knowing how inheritance tax is applied can help families plan their finances more effectively. For example, by knowing the rules of inheritance tax, a widow will be more prepared during this difficult time. Real-life examples are often the clearest way to illustrate how the rules work.

In this article, inheritance tax is explained, and you can see a straightforward breakdown of inheritance tax calculations using a simple scenario.

What Is Inheritance Tax?

Inheritance tax (IHT) is a tax applied to the estate of a person after their death.

The estate includes all property, money, and possessions they owned.

• It’s only charged when the estate exceeds a specific threshold, known as the nil-rate band.
• The standard threshold is £325,000 in the UK.
• The usual rate on the amount above this threshold is 40%.

Some assets may qualify for relief or exemption, such as certain types of business property or gifts given before death.

Married couples and civil partners can often transfer unused allowance between one another.

Here is a quick table overview of inheritance tax:

Inheritance tax is different from taxes paid on income or purchases, as it specifically targets the value left behind when someone dies.

Most estates in the UK don’t pay inheritance tax because they fall below the threshold or make use of exemptions.

Recipients or inheritors typically only pay if the estate’s value requires it, not automatically on all inheritances.

How Does Inheritance Tax Work?

Inheritance tax (IHT) is applied to the estate of a person who has died. This includes property, money, and possessions.

A key point is the tax-free threshold, known as the 'nil-rate band'. For most estates, this is £325,000. Only the value above this threshold may be subject to tax.

The standard rate of IHT is 40%. This rate applies solely to the part of the estate that exceeds the threshold.

Some estates can benefit from additional allowances:

• If a main residence is left to direct descendants, a residence nil-rate band may increase the threshold.
• For widows, inheritance tax exemptions apply to transfers between spouses or civil partners.

Example of a Calculation of Inheritance Tax:

Certain gifts made within seven years before death may also be taxed.

Some types of gifts and trusts can be exempt or taxed at a reduced rate, depending on the circumstances.

Executors or personal representatives are responsible for reporting the estate value and arranging payment of any IHT due. This is typically paid from estate funds before assets are distributed.

What Are the Current Inheritance Tax Thresholds?

The main inheritance tax (IHT) threshold for individuals in the UK is £325,000. This is known as the nil-rate band. Only the value of an estate above this threshold is liable for inheritance tax.

Married couples and civil partners can combine their allowances. This means a couple can potentially pass on up to £650,000 tax-free if no allowance has been used before.

Since April 2017, there’s also now a residence nil-rate band (RNRB). This extra allowance applies when a main home is passed to direct descendants, such as children or grandchildren.

For the tax year 2025/26, the residence nil-rate band is £175,000 per person. This is added on top of the standard nil-rate band.

A summary of the current thresholds is shown below:

Inheritance tax is generally charged at 40% on the value of the estate above these thresholds.

Certain gifts and transfers made before death may also affect the thresholds or exemptions available.

Individuals whose estates are below the thresholds don’t pay inheritance tax.

Any part of the threshold not used by the first spouse can normally be transferred to the surviving partner.

What Are the Rules on Gifts?

Gifts made during one’s lifetime can have an impact on inheritance tax (IHT).

The rules are specific, aiming to distinguish between regular gifts and those which affect an estate’s taxable value.

Most gifts become exempt from IHT if the giver lives for seven years after making the gift. This is known as the 7-year rule.

If the donor passes away within seven years, the gift may count towards the estate for tax purposes.

There’s an annual exemption, meaning each individual can give away up to £3,000 per tax year without the gift being added to the value of the estate. This annual exemption can be carried forward for one year if unused.

There are further exemptions for certain small gifts.

Up to £250 per person can be given each tax year to any number of people, provided they haven’t already benefited from the £3,000 exemption.

Gifts given on certain occasions are also exempt. For instance, wedding or civil partnership gifts have specific limits, depending on the relationship to the recipient.

The tax rate for gifts given in the three years before death is normally 40%.

If these gifts were given between three and seven years before death, a taper relief may reduce the tax due.

Gifts to spouses, civil partners, and charities are generally exempt from IHT, regardless of the amount.

How Does Inheritance Tax Work for British Citizens Not Living in the UK?

For British citizens living abroad, UK inheritance tax (IHT) can still apply based on domicile.

If an individual is classed as UK-domiciled or “deemed domiciled”, their worldwide assets may be subject to IHT.

If not UK-domiciled, only UK-based assets, such as property located in the UK, will usually be liable for IHT. This means foreign assets held by non-domiciliaries are typically not taxed by the UK.

The standard IHT threshold is called the nil-rate band, which is currently £325,000. Any value above this threshold is taxed at a rate of 40%.

Example of IHT Calculation for a Non-Resident:

There are some exemptions and reliefs, such as gifts made more than seven years before death.

Spouses and civil partners may have transfers exempt from IHT.

It’s important to note that definitions of domicile and residency are distinct for tax purposes.

Determining someone’s domicile can be complex and depends on their background and intentions.

British citizens living abroad are advised to review and plan their estate carefully to mitigate possible IHT liabilities on their UK assets.

How Does Capital Gains Tax Impact any Inheritance?

Capital gains tax (CGT) can affect inherited assets, but usually not at the moment someone inherits.

Beneficiaries face CGT only if they later sell the inherited asset, such as property or shares.

The value used to calculate any potential gain is called the “probate value” or market value at the date of the benefactor’s death.

If the asset increases in value between inheritance and sale, CGT may apply to that increase.

• No CGT is due just for inheriting an asset.
• CGT may apply if the inherited asset is sold for more than its probate value.
• HMRC will assess the gain from the difference between the probate value and the sale price.

Example of Taxable Gain Calculation:

Some personal allowances and exemptions may help reduce the CGT owed.

Beneficiaries should keep records relating to the inherited asset, such as valuations at the date of death.

Inherited assets aren’t subject to stamp duty or income tax at the time of inheritance.

CGT implications only arise if and when the asset is disposed of by the beneficiary.

Key Takeaways

In 2025, inheritance tax (IHT) in the UK applies to estates exceeding the £325,000 threshold, with a standard 40% tax rate on the amount above this limit. 

Gifts made within seven years of death may also be taxed, though there are exemptions, such as transfers to spouses and charitable donations.

A residence nil-rate band offers additional relief for estates passing a main home to direct descendants. 

British citizens living abroad may still be subject to IHT on UK-based assets, and careful estate planning is essential to minimise liabilities.