Inheritance tax explainedInheritance tax: thresholds, rates and who pays

Inheritance tax is no longer just a tax for the wealthy

Put simply, inheritance tax (IHT) is a tax on money or possessions you leave behind when you die, and on some gifts you make during your lifetime.

However, a certain amount can be passed on tax-free, which we call the 'tax-free allowance'. This is also known as the 'nil rate band'.

Everyone in the 2009-2010 tax year has a tax-free inheritance tax allowance of £325,000. The allowance was scheduled to go up to £350,000 next year, but in November's Pre-Budget Report it was announced that it would remain at £325,000 for 2010-2011.

There are also a number of gifts that you can make during your lifetime or in your will that are also tax free and these are covered later (see Inheritance tax planning and tax-free gifts).

Inheritance tax thresholds and rates

If you are single and die during the tax year 2009-2010 with an estate worth more than £325,000 (including money, property and investments, but after deducting debts and expenses such as funeral costs), 40% tax will become due on anything above £325,000.

For example, if you leave behind an estate worth £500,000 the tax bill will be £70,000 (40% on £175,000 – the difference between £500,000 and £325,000).

However, if you are married or in a civil partnership, you may be able to leave more than this before paying tax.

New inheritance tax rules for married couples and civil partners

Married couples and civil partners are allowed to pass their possessions and assets to each other tax-free and, since October 2007, the surviving partner is now allowed to use both tax-free allowances (providing one wasn’t used at the first death).

At the extreme, this effectively doubles the amount the surviving partner can leave behind tax-free without the need for special tax planning.

However, some people whose partner died before 21 March 1972 will be caught by a loophole. For more information see New rules for married couples and civil partners.

Making a gift

As well as on your estate at death, inheritance tax may also be payable on gifts you make during your lifetime, especially if you die within seven years of making the gift.

Gifts fall into four basic categories:

Always tax-free irrespective of when you make them – see Inheritance tax planning and tax-free gifts.
Potentially tax-free (known as potentially exempt transfers or PETs) – see Inheritance tax planning and tax-free gifts.
Taxable, but no tax due at the time the gift is made – see Taxable gifts.
Taxable, and tax is paid at the time the gift is made – see Taxable gifts.

Who pays the inheritance tax bill?

Inheritance tax that becomes due on money or possessions passed on when you die is usually paid from your estate. Basically your estate is made up of everything you own, minus debts such as your mortgage and expenses such as funeral expenses.

However, if the tax is due on gifts you made during the last seven years before your death, the people who received the gifts must pay the tax due.

If they cannot or will not pay, the amount due then comes out of your estate.

For more expert advice on tax rates and thresholds, read the Which? Essential Guide: Tax Handbook 2009/10.

Latest money news

For daily consumer news, subscribe to the Which? news RSS feed here. If you have an older web browser you may need to copy and paste this link into your newsreader: http://www.which.co.uk/feeds/reviews/news.xml. Find out more about RSS in the Which? guide to news feeds.

Or sign up for our weekly money podcast.