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How does inheritance tax affect beneficiaries?

A family gathered around a laptop asking themselves the question, "How does inheritance tax affect beneficiaries?"

If there’s inheritance tax on your estate, your beneficiaries will lose out. But how does inheritance tax affect beneficiaries in other ways apart from inheriting a lesser amount? Well, there are other impacts to consider, including cash flow challenges and disruption to a family business. (Before you read about these issues, we suggest you first look at, What is Inheritance Tax in the UK?)

But first, let’s quickly recap the rate of inheritance tax and how much you can pass on without tax becoming due.

What is Inheritance Tax?

Inheritance tax is the estate tax or “death duty” imposed on the estate of someone who has passed away. The word “estate” means all of your assets around the world, including your property, investments, and possessions.

You can pass on a certain amount free of inheritance tax and this is defined by your allowances. There are different allowances for individuals and married couples/civil partners, and also if you own a property that you’re passing to children and other lineal descendants. The two allowances, at the time this article was published were:

  • Nil Rate Band £325,000
  • Residence Nil Rate Band £175,000

These can be combined, allowing single people to pass on up to £500,000 free of inheritance tax and married couples up to £1 million. That’s providing you have a property you’re passing to lineal descendants. Otherwise, the limits are £650,000 for married couples/civil partners and £325,000 for individuals.

Anything above these limits is taxed at a rate of 40%. So how does inheritance tax affect beneficiaries?

Reduced Inheritance

Tax eats into your beneficiary’s inheritance because tax is calculated and paid first and assets distributed second. So beneficaries only receive their inheritance after tax has been paid. An estate worth £1.4 million is reduced to £1.24 million after tax. So the beneficiaries of your Will would lose out on £160,000 of their inheritance overall.

But consider what would happen if you are single or divorced at the time of your death. In other words, you either had not been in a marriage/civil partnership or else you divorced before you died. In that case, your executors would only have an allowance worth up to £500,000 to utilise. So the inheritance tax in this case would be £360,000 and the inheritance reduced close to £1m instead of £1.4.

Cash flow challenges

The executors of an estate may face a cash flow challenge to pay any inheritance tax that’s due. Inheritance tax has to be paid before any assets can be distributed. So if there’s insufficient cash in accounts to pay it, objects or property may have to be sold instead, or loads taken out to pay the tax bill. This could lead to assets being sold below their market value – for example, a property that has to be sold at short notice. This diminishes the overall value of a beneficiary’s inheritance, or an added debt burden for the beneficiaries.

Generational inheritance tax

Generational inheritance tax is where inheritance tax is paid multiple times on the same asset by successive generations. Imagine you die and you leave one of your children an inheritance of £500,000. This will immediately add to the size of their estate. As they get older and accumulate wealth, they’ll have their own savings and the benefit of their inheritance from you. So it’s not difficult to predict that their estate could easily be over their allowances when they die.

Of course, there are lots of other things that could happen before then – beneficiaries could lose money in a divorce, or pay for care fees, or simply spend it. But if they do hang on to it, inheritance tax will have been paid twice. And potentially their children will inherit it too.

In other words, HMRC gets a bite of the tax cherry with every successive generation. So the answer to “How does inheritance tax affect beneficiaries?” may be that future generations feel a greater impact than your children do.

Disruption to family businesses

If you have a family business, it could be the cornerstone of your estate. Beneficiaries inheriting family businesses may be forced to sell a portion of the business or take on significant debt to cover the tax liability. Potentially, this could jeopardise the long-term viability of the enterprise and impact the livelihoods of employees.

Summary

The question, “How does inheritance tax affect beneficiaries?” has a few different answers. Beneficiaries can lose out from inheritance tax in multiple ways if no planning is done. In my experience, many people are unaware of simple methods of avoiding inheritance tax – methods that are simple and completely above board. By planning ahead, you not only minimise the amount of inheritance tax your estate will pay – and maximise what your loved ones inherit – but you’ll also spare them the pain of some of the other problems that can occur as a result.

The information contained in these articles is for general interest purposes only. We take every precaution to ensure that the information is correct at the time of publishing but errors can occur. Given the changing nature of laws, rules and regulations, there may be omissions or inaccuracies in the information. Bristol Wills & Estate Planning Ltd is not responsible for any errors or omissions or for any results obtained from the use of this information. You should never rely on the information in these articles as a substitute for professional legal advice, whether from Bristol Wills & Estate Planning or any other legal service or professional.

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