What is inheritance tax?
Inheritance tax is a tax that must be paid on the estate of a deceased person in the UK if its value exceeds a certain threshold. The current inheritance tax threshold is £325,000 per person. This means that if the total value of the estate is above this amount, inheritance tax will be due on the excess at 40%.
For example, if a person died with an estate worth £400,000, the excess above the £325,000 threshold would be £75,000. 40% inheritance tax would be due on this £75,000, meaning a tax bill of £30,000.
Inheritance tax is payable by the deceased person’s estate, meaning it comes out of the value of their assets rather than being paid by the beneficiaries. The exception is when assets have been deliberately transferred out of the estate before death in order to avoid inheritance tax.
Why reduce inheritance tax?
There are several reasons you may want to consider reducing the amount of inheritance tax due on your estate:
– Minimise tax bill – Any tax savings can help maximise the value of assets passed to beneficiaries. Even a few thousand pounds of tax saved can make a difference.
– Benefit charities – Leaving money to charity is inheritance tax-free, so it can reduce the taxable value of your estate. Many people want part of their wealth to benefit good causes.
– Support family – Inheritance tax bills can sometimes force the sale of family assets like properties or businesses in order for beneficiaries to access funds. Planning can prevent this.
– Legacy planning – Some people want to pass on wealth in a way that secures the financial future of younger generations. Reducing inheritance tax helps create a larger legacy.
– Preserve wealth – If assets like property increase in value over your lifetime, this could inadvertently push your estate over the inheritance tax threshold. Planning helps protect wealth.
How is inheritance tax calculated?
Inheritance tax is only due if the value of your estate exceeds the current inheritance tax threshold when you die. For the 2022/23 tax year this threshold is £325,000.
If the total estate value exceeds the threshold, inheritance tax is charged at 40% on the excess.
For example:
– Total estate value: £400,000
– Inheritance tax threshold: £325,000
– Excess: £400,000 – £325,000 = £75,000
– Inheritance tax due: 40% of £75,000 = £30,000
This means there would be an inheritance tax bill of £30,000, leaving £370,000 to pass to beneficiaries.
The value of your estate includes the total value of your assets minus any debts. This potentially includes your home, money, investments, businesses, cars, jewellery, art, pensions and life insurance (unless written in an appropriate trust).
To arrive at the taxable estate value, you are able to deduct certain liabilities like funeral expenses, mortgage debts and any gifts you made earlier in your lifetime. Some assets also have specific exemptions from inheritance tax.
How to reduce inheritance tax
Here are some of the main ways you can potentially reduce the amount of inheritance tax due on your estate:
Lifetime gifts
Gifting assets to individuals during your lifetime can reduce inheritance tax if you survive the gift by 7 years. Different rules apply depending on the type of gift:
– Annual exemption gifts – You can give away up to £3,000 in total each tax year, exempt from inheritance tax. Any unused annual allowance can be carried over to the next year (up to £6,000).
– Small gifts – Gifts under £250 per person per tax year are exempt. This only applies if the person receiving them hasn’t already used their £3,000 annual exemption.
– Normal expenditure gifts – Gifts from your regular income that don’t affect your standard of living are also exempt. This could include paying grandchildren’s school fees or university costs.
– Potentially exempt transfers – Larger sums like a house deposit for a child are exempt after 7 years. Taper relief reduces tax liability if you die within 7 years.
– Marriage gifts – Special rules apply to gifts to someone getting married, up to certain limits.
By implementing a gifting strategy early in retirement or before later life, you can significantly reduce inheritance tax exposure over time as the 7 year periods elapse.
Charitable donations
Donating money to registered charities, museums, universities or community amateur sports clubs is an effective way to reduce inheritance tax.
These types of gifts can be made from your income or capital during your lifetime. Alternatively, you can leave up to 100% of your net estate to charity in your will and this will be deducted from the estate before calculating inheritance tax.
Just make sure the charity meets qualifying conditions and keep records of donations as evidence.
Use your annual inheritance tax allowances
Everyone has an inheritance tax allowance called the ‘nil-rate band’ that applies when you die. For the 2022/23 tax year this is £325,000. Any unused nil-rate band can be passed to a surviving spouse or civil partner on death to effectively increase their allowance.
In addition there is the ‘residence nil-rate band’ which applies if you leave a home to direct descendants. This is currently £175,000 per person, so £350,000 for a couple.
Making sure you fully utilise these allowances can significantly reduce or even eliminate inheritance tax bills for some estates. Proper will planning helps ensure you take advantage of gift exemptions and nil-rate bands.
Making gifts exempt from inheritance tax
Certain types of gift can be made totally exempt from inheritance tax no matter when you make them or their value. This includes:
– Gifts to your spouse or civil partner – These are exempt as long as they permanently live in the UK. Married couples and civil partners can effectively pool their allowances.
– Gifts to charities – Qualifying charitable gifts made during your lifetime or in your will are exempt.
– Gifts between spouses – If your spouse dies you can inherit their estate tax-free. The assets also change hands at their value on death, which can minimise capital gains tax.
Maximising use of these exemptions allows you to pass on wealth tax-free even above and beyond your allowances.
Make use of trusts
Trusts allow you to gift assets like money, investments or property, while still retaining some control and benefit. Different types of UK trust each have specific tax rules but they can be used to manage inheritance tax liability.
For example, placing assets in certain trusts removes them from your estate while still allowing you to be a beneficiary. Or trusts for children or grandchildren move assets outside of your estate once the 7 year exemption period has passed.
Setting up trusts requires expert legal and tax advice but can provide extensive flexibility inestate planning.
Life insurance policies
If structured appropriately using trusts, life insurance pay-outs can be made free from inheritance tax. This could provide a lump sum to cover any tax due on the rest of the estate.
The policy would need to be written into an ‘absolute’ or ‘discretionary’ trust, so the payout doesn’t form part of your legal estate.
This requires advice from a financial adviser or solicitor. Done correctly, it ensures the full sum can pass to beneficiaries without tax exposure.
Agricultural property relief
If you own farming assets like agricultural land and pastures, you can benefit from valuable inheritance tax reliefs like Agricultural Property Relief.
This means agricultural property in your estate is exempt from inheritance tax provided certain qualifying conditions are met. Make sure to take professional advice to ensure your property and assets meet the requirements to benefit from available agricultural reliefs.
Business property relief
If you own business assets such as shares controlling more than 50% of a trading company, you may be eligible for 100% Business Property Relief from inheritance tax.
You can also get 50% Business Property Relief on shares controlling more than 5% of a company’s ordinary share capital.
Business assets eligible for this relief are excluded when calculating inheritance tax. But businesses must meet qualifying criteria, so structuring business ownership correctly is important.
Pension funds
Some types of pension are exempt from inheritance tax as long as they remain untouched. This applies to most defined contribution pensions like SIPPs and group money purchase schemes.
However, withdrawals or transfers out of the pension during your lifetime could make benefits taxable later on.
Making full use of pension allowances during your working life is an effective way to build up substantial IHT-free savings.
Invest in AIM stocks
Shares on the Alternative Investment Market (AIM) can qualify for valuable Business Property Relief from inheritance tax once held for at least two years.
This relief applies regardless of the underlying business, making AIM stocks a tax-efficient investment option. However, AIM portfolios should be constructed for investment purposes first and foremost.
Investment in qualifying unlisted companies can also attract 100% inheritance tax relief, but this is higher risk and requires professional advice.
Maximise use of capital gains tax allowances
Selling assets during your lifetime provides the opportunity to make use of capital gains tax allowances like the £12,300 a year tax-free capital gains exemption in 2022/23.
If you make any gains above this threshold by disposing of second homes or investments, the capital gains tax rate is just 10% for basic rate taxpayers or 20% for higher/additional rate taxpayers.
Inheritance tax is potentially 40% so making lifetime sales to maximise capital gains allowances can be beneficial. Any gains eligible for holdover relief or entrepreneur’s relief also reduce future inheritance tax exposure.
Gift assets early
Gifting assets to intended beneficiaries well in advance of your death allows them to benefit from growth and income in the meantime.
The earlier you implement gifts, the sooner they will cease being counted as part of your estate for inheritance tax purposes once the 7 year period has elapsed.
Assets can be gifted directly or placed in trust. Either way, starting early maximises the time for assets to appreciate outside of the estate and provides more options.
Review inheritance tax planning frequently
A one-off exercise is unlikely to be enough when planning your estate and inheritance tax liability. Regular reviews let you monitor the impact of gifts, track allowance thresholds and keep your will up to date.
Events like marriage, divorce or grandchildren being born provide opportunities to update estate planning. Seeking ongoing professional advice ensures your arrangements remain tax-efficient.
Professional advice is essential
Reducing inheritance tax liability requires understanding a complex web of allowances, exemptions and reliefs. Rules differ hugely based on individual circumstances.
Without expert professional advice, it is easy to get things wrong and miss out on substantial tax savings. The costs involved in taking advice usually deliver a significant return on investment.
Specialist lawyers, accountants and financial planners can provide inheritance tax planning advice and ongoing support tailored to your situation. Though minimising inheritance tax does take time and planning.
Start planning early is key
Last minute arrangements shortly before death make inheritance tax savings much harder. Large gifts or transfers may be deemed tax avoidance without proper planning.
Starting inheritance tax planning early in retirement or even before retirement gives you time to make full use of exemptions, allowances and reliefs. It also avoids hastily prepared plans failing to achieve tax efficiency.
Seeking advice in your 50s or 60s allows a decades long, structured approach. Allowances and exemptions can be used systematically over time alongside estate planning.
You can’t escape inheritance tax completely
While there are allowances, exemptions and reliefs, inheritance tax isn’t easily avoided completely if you have a large estate. The nil-rate band and residence nil-rate band only total £500,000.
Professional advice is needed to structure your assets correctly to minimise tax. Even then you may need to pay some inheritance tax depending on the size of your estate.
Accepting this likelihood but implementing tax planning helps control and reduce the sums due. It also avoids falling foul of tax avoidance regulations.
How to find an inheritance tax specialist
To put an effective inheritance tax planning strategy in place, you need to work with specialist professionals experienced in estate planning. Some options to find help include:
– Ask your financial adviser for recommendations – Most advisers have trusted contacts they regularly work with.
– Search directories specific to tax and legal professions – These list experts you can review.
– Contact STEP members – STEP is a global professional association for inheritance tax specialists.
– Search locally online and check reviews – Personal recommendations are useful here.
– Ask at your bank or resource centre – Major banks have tax planning departments who can refer you.
– Talk to other professionals already helping you – Accountants or solicitors providing other services may specialise in this area.
– Consider a will writing service – Some offer inheritance tax planning as part of will writing packages.
Take time choosing who to work with and don’t rush into appointments. Getting recommendations can help identify reputable specialists.
Conclusions
– Inheritance tax planning should start early, allowing use of reliefs over time.
– Lifetime gifts and using allowances can significantly reduce inheritance tax due.
– Wills and trusts need to be structured professionally to minimise tax.
– Specialist advice is essential to navigate exemptions and allowances.
– Even large estates can reduce tax bills through careful planning.
– Accept some tax may still be due on higher value estates.
– Start planning in your 50s or 60s to make full use of available options.
– Review arrangements regularly and seek ongoing support.
With the right advice and planning, many estates can reduce or even eliminate inheritance tax bills completely. But the wider benefits of tax efficient estate planning go far beyond just inheritance tax savings alone.
