What Is The 7-Year Rule In Inheritance Tax?

Inheritance Tax (IHT) is one of the most misunderstood aspects of estate administration. It can cost your loved ones thousands of pounds when you die if you do not plan carefully, as any part of your estate that exceeds the tax-free threshold is taxed at 40%.

There are ways to minimise your estate's Inheritance Tax bill, but it is important to understand the 7-year rule before taking this approach. Working with the team at Percy Hughes & Roberts when writing your will can help you to consider the possible ramifications of your decisions.

Here, our expert wills and probate solicitors explain what the 7-year rule is, how careful Inheritance Tax planning can reduce the tax payable on your estate, and how Percy Hughes & Roberts can assist with either drawing up a will, administering an estate after death.

If you have any questions we have not answered, you can contact us by completing the enquiry form below or by calling 0151 666 9090.

What is Inheritance Tax?

Before we explain the 7-year rule, it is important to understand exactly how Inheritance Tax works. Inheritance Tax, sometimes written as IHT, is a tax on the estate of a person who has died. It is a one-off tax that must be paid within six months of the death.

A deceased person’s estate is made up of their property, possessions, and money. Once the value of the estate has been calculated, you will need to work out whether Inheritance Tax is owed.

You must pay Inheritance Tax at a rate of 40 percent on anything above the nil-rate band allowance. The standard nil-rate band allowance is £325,000 per individual. This means that the tax is only charged on the part of the estate that is above this threshold.

For example:

• Your estate is worth £400,000. The tax-free threshold is £325,000.
• The Inheritance Tax charged will be 40% of the difference, which is £75,000. In this scenario, the tax bill would equal £30,000.
• Any unused amount within the threshold can be passed onto a surviving spouse or civil partner

This can potentially bring their nil-rate band up to £650,000.

This is in addition to the main residence nil-rate band (RNRB), which is an extra nil-rate band when your estate includes a property that is being left to their children or other direct descendants, subject to certain criteria.

The current level for residence nil-rate band sits at £175,000.

This is a notoriously complex area of law and we would advise getting expert legal help to avoid any potential pitfalls.

What is the 7-year rule for IHT purposes?

Research conducted by Opinium suggests that the majority of British over-55s wish to leave an inheritance when they pass away. Their study also states that half of all adults are completely unaware of the 7-year rule when it comes to Inheritance Tax.

When you die, your executor will calculate the value of your estate and determine whether or not there is Inheritance Tax to pay. If the estate exceeds the tax-free threshold, your beneficiaries will pay Inheritance Tax at 40% on the remainder. This means that the value of the gifts you leave to beneficiaries could be significantly reduced in some cases.

The 7-year rule is used to determine which assets are considered part of your estate, which will affect its overall value. For this reason, understanding the 7-year rule means you can potentially reduce any potential tax liabilities that may be imposed on your estate, as physical or financial gifts given away at least 7 years before the person dies do not contribute to their estate, making the gift free of any IHT obligations.

How does the 7-year rule affect Inheritance Tax?

It is useful to understand how the 7-year rule works if you intend to use it to minimise the Inheritance Tax bill your family will face after you die. The rule applies specifically to gifts. “Gifts” in this sense does not mean items that are wrapped in ribbon and paper, but anything that has value more generally, i.e. possessions, money, and property. While some gifts are exempt from Inheritance Tax, most gifts are subject to Inheritance Tax rules.

Taxable gifts can be split into two categories. Chargeable lifetime transfers (CLT), which relate to gifts that are paid into a discretionary trust, can be subject to an immediate 20% Inheritance Tax charge. You pay IHT on these gifts when the transfer is made, before you die.

The second category, potentially exempt transfers (PET), is where the 7-year rule can become effective. A PET gift can be completely tax-free if you live for 7 years after gifting it to an individual. If you die within 7 years of gifting the asset, it will count towards the value of your estate and the £325,000 of the IHT nil rate band. After 7 years, the gift does not count towards the value of your estate, which is known as “the 7-year rule” for Inheritance Tax purposes.

If you give a gift and die between 3 and 7 years after handing the asset over, the Inheritance Tax band is tapered on a sliding scale. This scale is:

This rule is why, very often, parents will give their children or grandchildren gifts long before they believe they will pass away, in order to take advantage of taper relief and avoid paying tax on the gift.

Gifts that are exempt from tax

If you think your estate is worth more than the £325,000 Inheritance Tax threshold, you should start thinking about how to minimise the potential tax liability that your loved ones will have to deal with when you pass away.

One of the most straightforward ways to avoid Inheritance Tax is to consider giving away assets while you are still alive. Below we detail some of the most popular tax-free (and tax-efficient) options for giving away gifts:

• £0 - Tax paid when gifting to a spouse or civil partner, including when you die
• £0 - Tax paid on gifts given for the maintenance of old relatives
• £0 - Tax paid on gifts to charities or political parties
• £3,000 - Amount you can gift tax-free in a tax year, known as “annual exemption”
• £5,000 - Amount you can gift tax-free to your children for their wedding
• £250 - Amount you can gift tax-free to someone who hasn’t already benefited from your annual £3,000 exemption
• 18 - Maximum age you can gift your children with maintenance for their education tax-free

Firstly, your civil partner or spouse will not pay any Inheritance Tax on assets gifted to them, even if it is within 7 years of your death. This is because you are allowed to pass your estate onto the surviving partner when you die, tax-free. This is known as the spousal exemption.

You are also allowed to gift up to £3,000 in a tax year, known as an “annual exemption”. After this exemption, you can gift a further £250 to individuals who haven’t benefited from that initial £3,000.

A parent can gift their child £5,000 for their wedding, completely tax-free. You are also able to give gifts to charities and political parties without paying any tax. Using gifts in this manner means you can start to reduce your tax liability and bring the total value closer to £325,000.

It should be mentioned that this blog provides a general overview and there are various rules and exceptions surrounding the availability of the nil rate bands, exemptions and the 7 year rule.

How can Percy Hughes & Roberts help?

At Percy Hughes & Roberts Solicitors, we have a team of dedicated wills and probate solicitors who are ready to help you resolve your query or issue relating to this area of the law as quickly and effectively as possible.

If you need help in dealing with writing a will, managing Inheritance Tax on an estate, or simply want guidance on Inheritance Tax more generally, our wills and probate solicitors have a wealth of experience. They can assist you in this complex area of law and ensure you leave your loved ones in the best possible situation.