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Inheritance tax planning

How IHT works

IHT is set at a flat rate of 40% on your death (or 20% if you make a chargeable lifetime transfer - your financial adviser will be able to tell you when this might apply). It's payable on the value of your estate above what's known as the nil rate band, which is set at £325,000 in 2009/2010.

How IHT is calculated

Your estate is made up of everything you own, including your home, investments, any valuables and your share of any jointly owned items. Everything you owe, for example, your mortgage or a bank loan, is deducted from the value of everything you own to work out the net value of your estate. It's this net value that IHT could be payable on.

An example - how IHT is calculated

George dies with a net estate value of £500,000. He has his full nil rate band available to offset some of his IHT liability.

IHT calculation:

Value of net estate less available nil rate band = Amount liable to IHT

£500,000 - £325,000 = £175,000 (the amount liable to IHT)

£175,000 x 40% = £70,000 (the amount of IHT payable on George's death)

This means only £430,000 passes to his beneficiaries. That's his net estate of £500,000 less IHT of £70,000.

Transferring the IHT nil rate band

Recent changes to legislation mean married couples or couples in a civil partnership can transfer their nil rate band to their partner on their death.

This means any unused nil rate band from the first death can be carried forward and used when the surviving spouse dies on or after 9 October 2007. In the past, couples leaving their assets to their spouse IHT-free wasted one of their available nil rate bands.

An IHT example - transferring the nil rate band

James dies in 2007 with an estate of £300,000, when the nil rate band was £300,000. He gave away £50,000 to his children, leaving £250,000 to his wife, Sheryl.

As estates passing to a surviving spouse or civil partner are exempt from IHT, this means James didn't use £250,000 of his nil rate band on his death.

The percentage of James' unused nil rate band is worked out as follows:

£250,000 ÷ £300,000 x 100 = 83.3%

If Sheryl died during the current tax year 2009/10 (nil rate band of £325,000), her combined nil rate band would be £595,725 - her full £325,000 band plus £270,725 in respect of James' unused nil rate band. This is worked out as shown:

83.3% of £325,000 = £270,725
+ £325,000
= £595,725

One thing to remember is that the percentage that has been unused stays the same until you die. For example, if in 2010 the nil rate band is £350,000 and you were to die in that year then you can use the 83.3% of £350,000.

The importance of a valid will

It's important to remember that, if you don't make a valid will, the law dictates who receives what from your estate when you die. This could mean that your estate won't be divided up as you would have wanted. For example, your partner wouldn't automatically inherit your whole estate.

Your financial adviser will be able to give you more information on what the law says should happen when someone dies without having a valid will in place.

All references are to UK inheritance tax, which is generally only applicable to UK domiciled individuals.