An inheritance tax (IHT) is imposed on property that has been gifted or inherited. Even though IHT is charged upon death, it may also be owed on some gifts given before death. If you’re giving money, you need to know whether the donation is tax-deductible or a later tax bill. Understanding the seven-year gift rule for inheritance tax purposes is crucial. Therefore, it’s necessary to understand briefly what the term “inheritance tax” means in the simplest terms and what the seven-year rule in estate planning is.
What is an inheritance tax in estate planning?
An inheritance tax is essentially a charge on a deceased person’s estate (i.e., money, goods, and property). The one-time tax is due within six months following the donor’s passing. Because prior gifts are considered for determining the amount of tax owed, IHT is also known as a cumulative tax. Since the tax is uncommon in the United States, therefore, it depends on the state where the deceased resided or owned property. The amount of the inheritance and the beneficiary’s relationship to the dead. This will determine whether it applies in one of the six states with an inheritance tax as of 2022.
Only the amount of an inheritance that surpasses an exemption level is subject to an inheritance tax if one is required. Above these levels, tax is often imposed using a sliding scale. Typically, rates rise from the lower single digits between 15 and 18 percent. More so than the size of the assets you are receiving, your relationship with the deceased may affect both the exemption you obtain and the rate you pay.
Gifts received three years before your death are subject to a 40% tax. A sliding scale of taxes is applied to those given three to seven years before dying (taper relief). For instance:
- From 3rd to 4th year – a 32% tax applies.
- Between the 4th and 5th years – a 24% tax applies.
- Between the 5th and 6th years – a 16% tax applies.
- For the 6th and 7th years, – 8% tax applies
- Over seven years, the tax applied is nil
The seven-year rule of inheritance tax in estate planning-
“Potentially exempt transfers” are gifts made to those who aren’t immediately exempt from taxes. For example, they won’t be tax-free if you pass away within seven years of giving the gift. Several gifts fall within the category of exempt from inheritance tax. Everything else is classified as either a potentially exempt transfer (PET), where the facility will be completely tax-free if you live for seven years after making it, or a chargeable lifetime transfer (CLT), which is for gifts into discretionary trusts that may be subject to an immediate 20 percent IHT charge (if paid by the trust, or 25 percent if paid by the settlor) (assuming that the gift has been given to an individual, instead of a business or trust).
As we noted above, if you pass away within seven years after gifting that asset, the gift will count toward your nil-rate band and may thus still be subjected to IHT. If the value of your estate exceeds the nil-rate band, inheritance tax will be paid to HMRC using funds from your estate. The person in charge of the estate (the executor if there is a will) will take care of this. When it comes to gifts, the recipient can be required to pay IHT if the donor passes away before seven years have passed. Remember that some contributions you make while you’re still alive won’t be subject to inheritance tax if you wish to preserve your fortune for your loved ones.
Gifts exempt from inheritance tax include:
- Gifts that support your relatives (such as an ex-spouse or former civil partner, a child, or some other dependent kin) with living costs are exempt from inheritance tax.
- Charity donations: You are exempt from paying inheritance tax if you donate to charities, colleges, museums, and local sports teams.
- Gifts made from your income – You can give gifts from your regular income, such as Christmas, birthday, anniversary presents, recurring payments, life insurance policy payments, etc., as long as the facility doesn’t impact your everyday quality of living.
How can an estate planning attorney assist in this matter?
Following are how an estate planning attorney may guide you regarding the 7-year rule:
- They can specify how much cash you can spare to donate without running out in the future
- They can guide you to manage best or lower an inheritance tax obligation if you are expected to do so.
- They can inform you if the recipients of your gifts might be subject to tax penalties
- They can state whether creating a trust or making direct gifts would be preferable.
The seven-year rule in inheritance tax in estate planning has the primary purpose of ensuring that people who have not been listed as beneficiaries will prevent from taking a person’s assets by manipulating them before their demise through vast amounts of taxes.