If you hate the idea of HMRC receiving a large chunk of your estate when you die, read these expert tips on how to reduce your ‘death tax’ bill or, better still, leave your heirs with no tax to pay.
Inheritance tax (IHT), commonly known as the ‘death tax’, is a tax on the estate – property, money and possessions – of someone who has died.
It’s a tax dreaded by the middle classes almost as much as the Grim Reaper himself. Yet, surprisingly, it doesn’t affect a huge number of people. According to figures from Her Majesty’s Revenue and Customs (HMRC), for deaths in 2014/15, the number of estates with a liability to IHT was 23,250, which was about 4% of all the estates left on death in the UK (approximately 597,000 in total).
Yet, IHT receipts have increased year on year since 2009/10, on average by 11% each year. Moreover, with house prices having risen, in the South East in particular, an increasing number of people are finding themselves liable for it. According to HMRC’s own figures, approximately £4.8 billion was collected in the 2016/17 tax year.
The IHT allowance
IHT is normally charged at 40% of the value of your estate above a certain amount, known as the inheritance-tax threshold or nil-rate band, which is £325,000 for the current 2018/19 tax year.
However, married couples can combine their IHT thresholds, meaning that up to the first £650,000 of their combined estate is IHT-free, as any unused nil-rate band can normally be passed on to the surviving spouse.
In April 2017, an IHT tax break was also introduced on the family home. This means an individual can transfer an additional £125,000 this tax year to their direct descendants – rising to £150,000 in the 2019/20 tax year and £175,000 in 2020/21.
Adrian Lowcock, investment director at multi-manager Architas, explains: “This effectively means that, by 2021, an individual will have IHT-free allowances of up to £500,000, and married couples or civil partners, who can inherit any unused allowance from their spouse, could pass on up to £1 million before they have to pay IHT.”
Nevertheless, after years of grafting, saving and paying taxes, most are reluctant to allow the tax authorities to take money from their estate.
IHT law is relatively complex, but there are plenty of legal ways to avoid it. Danny Cox, head of communications at financial provider Hargreaves Lansdown, stresses that “one of the best ways to reduce the amount of IHT that will be paid on your death is to reduce the value of your estate”.
Moneywise reveals three top tips to cut your IHT bill.
1. Gift smaller sums
Gifts to your spouse or registered civil partner and to registered charities and political parties are IHT free.
In addition, you can gift £3,000 of capital each year, which is known as your annual exemption. If you didn’t use last year’s allowance, this can also be used.
You can also make regular gifts from your income, but you must show that such gifts leave you with sufficient money to maintain your standard of living.
IHT law is complex, but there are plenty of legal ways to avoid it
Wedding or civil ceremony gifts are also allowed. You can give up to £1,000 to a relative or friend, up to £5,000 to a child or up to £2,500 to a grandchild or great-grandchild.
In each tax year, you can also gift up to £250 to any number of people completely free of IHT, provided you’ve not used another exemption on the same person.
2. Gift larger amounts
You can also reduce your IHT by giving away larger financial sums, but you must live for at least seven years from the date of the gift for it to be completely free of IHT. These gifts are known as potentially exempt transfers and are taxed on a sliding scale known as taper relief (see box, below).
Tim Fullerlove, a partner at Wilsons Solicitors, warns, however, that you must not benefit from the money or assets you give away. If you do, even in a small way, your estate will still pay IHT on the asset when you die.
Mr Lowcock adds: “Much IHT planning involves giving away some of your money early and, as such, you lose the benefit and access to that money.
“This needs consideration, because, while you might not need the money today, you could find you might need it later in life, for healthcare, for example.”
One common concern when making large gifts, particularly to younger children, is whether the recipient will spend it wisely. Fortunately, it is possible to give money away while retaining control over its use by way of a trust arrangement.
How taper relief on gifts works
|Number of years between gift and death||Percentage of gift liable for inheritance tax (%)||Effective rate of inheritance tax (%)|
|Less than three years||100||40|
|Three to four years||80||32|
|Four to five years||60||24|
|Five to six years||40||16|
|Six to seven years||20||8|
|More than seven years||0||0|
Source: Gov.uk, 5 July 2018.
Mr Fullerlove explains: “Trusts are a complex topic, but there are a variety of structures that allow you to give money away, achieving the tax savings of a gift, without giving the children or other recipients control over it.
“You, or other chosen trustees, can hold the money on behalf of the recipients and use the funds to support them until you feel they are financially mature enough to have the funds themselves. If you give more than £325,000, on current values, to a trust you will trigger an immediate tax charge – but gifts up to this threshold will, again, be free from IHT if you survive for seven years.”
3. Invest your cash
Some investments also qualify for relief from IHT after two years – although there are risks and the rules can, again, be complicated.
Julia Rosenbloom, private-client tax partner at accountancy firm Smith & Williamson, explains that if you’re a small-business owner, for example, and have held the business for two years before death, then it may be that the value of the business qualifies for business property relief (BPR) at 100%.
However, she warns: “Sometimes the way people operate or structure their businesses, or the assets held by the business, can jeopardise either the amount of IHT relief available or even whether IHT relief is available. Therefore, business owners should review how they manage things, to ensure they qualify for BPR.”
If the business premises are owned (rather than leased), for example, but are held outside the company, only half the business value will qualify for IHT relief, compared with 100% if held within the company structure.
Qualifying Enterprise Investment Scheme (EIS) companies, certain AIM (Alternative Investment Market) shares and unquoted shares also qualify as free from IHT if held for two years.
Unfortunately, BPR is not available for AIM stocks where the business mainly deals in land or buildings or the making or holding of investments.
It is possible to give money away while retaining control of its use
However, if you choose wisely, it’s possible to have AIM shares in an Isa that benefit from tax-free growth and dividends which, if held for two years, can also be passed on free of IHT after death.
Mr Cox points out: “There are packaged schemes offered by selected investment companies that invest in AIM portfolios and unquoted shares for their IHT benefits.”
Of course, all these investments carry additional risks, and Mr Lowcock stresses: “Investors should be wary of jumping into these investments both feet first, as you could easily lose more than you gain from the tax avoidance. Don’t let tax drive your investment decisions; any investment should be sound on its own merit first.”
Ensure money is accessible on death
Ian Dyall, head of estate planning at wealth management firm Tilney, adds that the final step in IHT planning is to ensure that your executors have the money available, prior to the grant of probate, to pay any remaining tax liability.
He advises: “This can often be most efficiently achieved by holding life-assurance policies in trust to pay any remaining liability.”
How Mr & Mrs Smith’s estate could pay no IHT
Tim Fullerlove, a partner at Wilsons Solicitors, provided the following example of how IHT can potentially be avoided.
Mr and Mrs Smith have assets together worth £1.25 million. They both die in 2021 and leave their entire estates to their three children. In the tax year 2020/21, their combined IHT allowances will total £1 million. Their estates will pay IHT on £250,000, resulting in a tax bill of £100,000.
However, imagine that Mr and Mrs Smith have been making tax-saving gifts for the seven years before they die. They have each given £1,000 to each child each year, using up their £3,000 annual allowance and giving away £42,000 between them over seven years. All three children have got married over the past few years and Mr and Mrs Smith each gave each child £5,000 for their weddings, giving away another £30,000. They have felt able to give away another £10,000 each from their income to each child each year, for another £420,000. This means they have given away a total of £492,000 over the seven years.
These gifts are all immediately IHT-free, with no requirement to survive seven years. As a result, no IHT will be due on their estates.
CHRIS MENON is an editor and writer who has contributed financial articles to the Telegraph, Guardian and Independent on Sunday