Tax & admin · 2 June 2021

Does inheritance tax apply to your spouse?

Does inheritance tax apply to your spouse?

Being a breadwinner for your family takes enormous amounts of planning, careful research, and constant observation of legislation. Preparing for the protection of your loved ones includes using finance tools like life insurance to keep them financially secure or tax-free investments to reduce Inheritance Taxes (IHT) on your estate.

Today we are looking at the question of whether inheritance tax applies to the estate willed to your spouse. Firstly, let us get the basics out the way:

What is a will?

The point of your will is to distribute your estate amongst beneficiaries. It will also name the person who shall be responsible for administering your estate (the executor). Additionally, it will name who will care for your children upon your passing and will relay any requests for special arrangements you would like.

A will written by yourself is a legal document, but due to the complexities of allocating an estate in the most tax-efficient way, it would be prudent to get legal advice. Making unwitting mistakes can cost your beneficiaries up to 40% IHT or may open the will to being contested or may cause the will to be declared invalid.

Without a will, your estate may be divided between your spouse and progeny if your estate exceeds £250,000, instead of just going to your spouse.

The correctness of your will is even more important if you have a blended family, which is becoming a contemporary norm. Some parents may want to ring-fence their assets for their own direct children. In that instance, you can use the formation of a trust under your will to achieve that outcome. Your second spouse can be given permission, under the will, to live in any property of yours until their death. They will then also ensure that the property will finally go to your children at the time of your second spouse’s passing.

On the other side of the coin, you can exclude offspring, or anyone you wish, from your will. This may cause potential future claims on your estate, and this would need to be considered in the construction of the will. A solicitor can advise you on mechanisms that you can utilise in order to reduce the risk of any potential claims, even if you ultimately write the most of the will yourself. Your will’s thoroughness and correct structuring are very important if an exclusion is one of your goals.

Suppose, unfortunately, an unwitting error has caused your will to be declared invalid. In that case, this could result in all your beneficiaries losing out on your carefully considered distribution even though it is written down.

Ensure your will is valid, obtain legal advice – the costs are affordable and minimal compared to the risk.

Executors, witnesses, beneficiaries and will rewrites

Your spouse can be the executor of your will as well as the beneficiary under your will; however, a witness may not be a beneficiary and, by doing this, would make the will invalid.

In the instance that your executor passes away before you do, you will need to have an appendix prepared in which new executors are named. Checking up on your will, from time to time, is a good idea as you can reassess if your assets are up to date and that you are happy with distribution and trustees.

Further on updates, if you enter into a second marriage, your will is automatically revoked unless it was created in advance of the marriage and specifically refers to the marriage and the new spouse, be that as an inclusion or exclusion.

Interestingly, a divorce does not revoke your will. If any clauses within it refer to your ex-partner by name, they are treated as though your ex-partner predeceased you. However, it is highly advisable to consider rewriting the will to mitigate claims against your estate and delay the distribution of assets to your other beneficiaries.

Inheritance tax on life insurance payouts

There is not a one-size-fits-all line between a life insurance policy payout and inherited wealth. When purchasing insurance policies or investments of any kind, you need to ask the seller of the financial vehicle if it, e.g. the life insurance policy, is taxable and the expected amount of tax.

To make your investment as efficient as possible for your spouse and perhaps offspring as well, you need to be talking with a financial service professional who has success in inheritance tax law advice.

Life insurance policy payouts are not specifically referred to in IHT legislation, but the amount that is paid out is the factor that triggers IHT. The IHT of 40% is triggered if:

  • The total value of the payout, based on the 2021 tax law, is over £325,000
  • And you are single or divorced,
or

  • The total value of the payout, based on 2021 tax law, is over £650,000
  • And you are married or widowed.
As the tax scales have not kept pace with rising house prices (300% over the past decades) and inflation, those trigger values are very quickly reached. House prices combined with savings, investments, and precious family heirlooms quickly add up to the tax point for the average middle-class family. Had the tax scales kept pace with realistic property pricing and inflation, only the super-rich would be affected by the IHT with vast amounts of estate value. In the current scenario, vital inheritance needed by your spouse to survive, and created from years of astute and painstaking saving, is being consumed by IHT.

Using a trust fund is one solution, but it is not a total solution.

Writing life insurance into a trust

If your life insurance policy does pay into a trust, access to the funds will be managed by trustees. You also can set guidelines on how, where, and to whom the fund is paid out. For instance, you might instruct the fund to wait until your children are 18 until the fund pays out to them.

It is prudent to write the insurance policy into your will with the instruction to pay it into a trust.  This speeds up the paying out of it, as probate is not needed. If it does not pay into a trust, or the benefactor has died without a will, then the probate process can take months.

Are trusts simple solutions?

Trusts do help with strategically managing IHT but do not wipe it out. Furthermore, trusts are complicated vehicles, and it is best to engage the services of a solicitor.

You are expected to define your wishes regarding the terms of the trust, e.g. who is paid, how much can be paid, and for what. When you assign your life insurance to a trust, you are automatically a trustee. The trust terms are difficult to change, so you should read through the fine print of the particular trust you intend to use.

Married or civil spouses and IHT

HMRC does permit the passing of assets from one spouse, of a UK-domiciled married couple, to their other spouse (or registered civil partner) without having to pay inheritance tax. This applies equally during their lifetime or when they die and does not limit how much they pass on. This is known as spouse or civil partner exemption. There is a limit, however.

The surviving spouse can claim the proportion of their partner’s nil-rate band, which wasn’t used on their death, in addition to their own entitlement. Therefore, your surviving spouse can benefit from a nil-rate band allowance of up to £650,000, ONLY if you, the deceased, did not use any of your nil-rate band.

You can also transfer your residence nil-rate band, introduced in 2017, to your spouse; therefore, you can pass on a residence to direct descendants such as children, grandchildren, stepchildren, adopted and foster children. The residence nil-rate band allowance is £175,000 a person. Again, there is a limit – these amounts are capped subject to the value of the property.

Because unused allowances can be transferred from partner to partner, you and your spouse or civil partner could have a combined nil-rate band allowance of £1 million (capped) at your time of passing.

Everyone is entitled to an allowance for use on their Estate. You can transfer assets up to a certain value without triggering IHT. This is called the ‘nil-rate band’, which is currently set at £325,000 for individuals. Married couples, or those in a civil partnership, have additional benefit advantages.

Residence nil-rate band is an additional benefit for your spouse as well as gifting. As a finance tool, Gifting can be used to transfer funds across to a spouse without incurring IHT. Let us look at these different options.

What is spouse exemption?

Transfers and Estates can be passed on to a surviving spouse or civil partner, with a cap, of course, viz £1m, and that amount will be fully exempt from Inheritance Tax.

What is a transferable nil-rate band

Each spouse or civil partner can utilise the nil-rate band of their pre-deceased spouse as long as it has not already been used on their Estate. This means that any proportion of allowance not used on the first death can be used on the second death. This would result in a maximum double tax-free allowance of £650,000.

An example of spouse exemption applied with transferable nil-rate band

For this example, we will use Mr and Mrs Citizen, who are married but unfortunately, Mrs Citizen passes away. She leaves her entire estate to Mr Citizen and, with spouse exemption applied, no Inheritance Tax is payable, and none of Mrs Citizen’s nil-rate band needs to be used.

Many years later, Mr Citizen dies, and his final estate is worth £500,000.

  • Mr Citizen’s individual nil-rate band is £325,000.
    • Any amount over this threshold would be liable for Inheritance Tax.
  • Mrs Citizen’s nil-rate band of £325,000 was not used.
    • This is transferred for application to Mr Citizen’s Estate.
    • Mr Citizen’s nil-rate band is therefore increased to £650,000.
  • Mr Citizen’s Estate is therefore not liable for Inheritance Tax.
To claim your transferable nil rate band, you need to complete an IHT 217 form and file it with the HMRC.

What is the gifting finance tool?

Gifting that is done long term and systematically is a viable option, up to a point, as any lifetime gifts that are made in the seven years prior to your demise might reduce the nil-rate band allowance.

If Mrs Citizen, who passed away first, had made gifts worth £125,000 two years before her passing, this would have been taken off her nil-rate band, thus leaving £200,000 unused. Mr Citizen would only have benefited from £200,000 second death Estate. His nil-rate band allowance would have been £525,000 which would still have covered his estate, but it is something to monitor.

You are entitled to give gifts of up to £3,000 per year without these being taxable. In some instances, you can utilise two (maximum) annual exemptions for the same transfer, which will push the gift total up to £6,000.

A Residence Nil-Rate Band

This is an additional benefit for your spouse. This benefit can be added on top of the existing nil-rate band. As you would expect, it is not without the need for certain criteria to be met to qualify for this benefit.

The residence nil-rate band benefit relates specifically to the exemption of the deceased’s main place of residence. This must also have been their place of residence when they passed away.  The residence must be written into the will as being transferred to children or other ‘direct descendants’, and only one home will qualify. A second property would not qualify.

This allowance increases the tax-free amount that an individual can pass on by £100,000.

Conclusion

Inheritance tax does apply to your spouse; however, there are exclusions which they can benefit from, and there are financial tools that can be utilised to reduce the impact of IHT Avoid inheritance tax by following the law. Here’s the loop.

Creating a will is not merely about committing your wishes to a piece of paper, albeit that this is the first step. To ensure that your beneficiaries get the maximum benefit from your assets is might be necessary to take action on distribution before your demise, such as annual gifting.

Pre-plan your will, review it regularly and use a professional to avoid claims or an invalid will.

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