Are you familiar with the seven-year inheritance tax rule in the UK? It’s an important part of estate planning, and could potentially reduce the amount of tax payable on an estate.
The rule affects how gifts that are made over the course of someone’s life are treated for the purposes of inheritance tax.
In this article, we’ll explain how the rule works. This mini guide may be particularly relevant if you are an older person who has built up substantial wealth and wants to pass assets to family members in a tax-efficient way, or for those of any age who are beginning their own long-term financial planning (https://www.harteywm.co.uk/services/inheritance-tax).
What is the 7 year inheritance tax rule?
Potentially exempt transfers (PETs) are gifts given by one person to another during their lifetime.
In the UK, inheritance tax rules dictate that if the person making the gift survives for seven years after giving it, the gift is exempt from inheritance tax. In this scenario, the PET will not form part of their estate when inheritance tax is calculated after they have passed away.
Let’s say a parent gives £300,000 to their child to help with an investment, or simply for their future financial security. If the parent survives for seven years after making the gift, no inheritance tax would be payable on the £300,000 under the rule.
What happens if you die within 7 years?
You should note that the gift may still be subject to inheritance if the person who made the gift dies within seven years.
The tax amount will vary according to; the gift’s value, the overall value of the estate, applicable inheritance tax allowances and exemptions, and the timing of the gift before the person passed away.
On estates above the available tax-free thresholds, inheritance tax is usually charged at 40%. Gifts made within the seven-year period are added back into the estate calculation, starting with the oldest gifts.
The estate usually pays for the inheritance tax due on a lifetime gift. If there are insufficient funds, the gift recipient may be required to pay the tax.
Taper relief (3–7 Years)
Taper relief is a UK inheritance tax reduction that is applied to gifts made 3-7 years before death. It reduces the tax on the gift, rather than its value.
If the person survives for at least three years after making the gift, taper relief applies to the tax due.
Taper relief reduces inheritance tax rates as follows:
- 3 to 4 years – 32%
- 4 to 5 years – 24%
- 5 to 6 years – 16%
- 6 to 7 years – 8%
After the seven-year period, the gift usually becomes exempt from inheritance tax.
Gifts with reservation
We should mention an exception to the seven-year rule.
It does not apply where the donor continues to benefit from the gifted asset. This is known as a gift with ‘reservation of benefit’.
A common case of gifts with reservation is the ownership transfer of a house to a child while they continue to live in the property rent-free. In this scenario, HM Revenue and Customs (HMRC) may still treat the property as part of the donor’s estate when it comes to inheritance tax, even though legally the ownership has changed.
Although ownership may have changed legally, HM Revenue and Customs (HMRC) may still treat the property as part of the donor’s estate for inheritance tax purposes. As a result, the asset could remain fully taxable on death.
Inheritance tax gift exemptions
There are several exemptions to the seven-year rule which permit individuals to pass on wealth without paying inheritance tax.
These include; an annual gift allowance of £3,000, carrying forward one unused year of this £3,000 allowance, wedding or civil partnership gifts (within certain limits), regular gifts from extra income.
Who pays the seven-year inheritance tax?
Inheritance tax is paid from the deceased person’s estate. Assets are then distributed to beneficiaries.
When gifts made within seven years carry an inheritance tax liability, the recipient of the gift may become responsible for paying the tax if the estate is not sufficient to pay the amount.
Inheritance tax planning can involve significant sums of money. Ensure you receive the best professional financial and legal advice – get in touch with the friendly team at Hartery WM; we’ve been helping clients with investment planning in Cheshire for 25 years.
