Inheritance tax is the UK’s most hated tax according to a recent article in The Independent. Over £5bn was paid to the Treasury in the last tax year and the number of estates paying inheritance tax has almost doubled since 2011. What can you do about it?
Let’s start with some good news.
Most people don’t have to pay inheritance tax, because it only applies at the time of one’s death. In some cases, inheritance tax is payable during your lifetime, for chargeable lifetime transfers above the nil rate band.
Where do you live? An important question, because house values have a huge effect. Yes, there is a postcode lottery when it comes to inheritance tax.
Source HMRC 2014-15
The London/South East area has a high volume of expensive housing. The value of your home, minus any debt, is caught in the inheritance tax calculation.
The money raised in tax in 2017-18 was £5.3bn. This represents only 1% of the entire UK tax revenue. There is an awful lot of bad feeling towards that 1%.
Here are a few simple factors to help you see if you will pay inheritance tax.
- Is the value of everything you own £2m or less?
- Are you married or in a civil partnership?
- Do you have direct descendants who will inherit your home?
If you answered yes to each question, then it is likely that, subject to meeting various conditions, the first £900,000 will not suffer any inheritance tax at all (2018-19). This will rise to £1m by 2020-21.
The structure of inheritance tax (IHT)
IHT is levied on the value of a person’s estate at the time of their death. The tax is charged at 40% above the tax-free threshold. In the majority of cases, tax is levied at death, although there are circumstances where gifts by individuals to discretionary trusts or companies are immediately chargeable to tax – and in these cases, tax is charged at 20% on any excess over the tax-free threshold.
Certain gifts are exempt from tax, irrespective of their size and whether they were made during one’s life or under the terms of one’s will. These are:
- Gifts made to one’s spouse or civil partner.
- Gifts made to charities.
- Gifts made to political parties.
- Dispositions for the national interest.
The 10 ways to cut your inheritance tax
1. Give your money away
Simple really. What is known as the ‘seven-year rule’ came in during 1986. This is when inheritance tax replaced capital transfer tax. The technical term is a ‘potentially exempt transfer’ or PET. It will be a PET if gifted to an individual or an absolute trust, or a ‘chargeable lifetime transfer’ (CLT) if gifted to a relevant property trust.
Any ‘property’ can be given away (money, cars, jewellery etc.). There is no upper limit on PET gifts. There will be an immediate charge to IHT at 20% on the excess if it is a CLT (on its own or when added to other CLTs in the previous seven years) that exceeds the nil rate band.
This allows you to “give with a warm hand instead of a cold hand.” All you have to do is survive for seven years. After that, the value of the PET/CLT is excluded from the calculation of tax on your estate when you die.
You can give to as many people as you like. A gift is a gift, no strings attached.
Some parents choose to downsize in their sixties and pass on surplus cash to their children. This reduces the value of the parents’ estate, they should survive seven years, and the children benefit when they need it most.
2. Make qualifying gifts
There are gifts you can make where the seven-year rule doesn’t apply.
- A gift to a registered charity.
- A gift to a formal political party (two MPs or one MP with at least 150,000 votes in a general election).
- A gift for a national purpose (museums, universities etc.).
If these gifts qualify under the rules, they are 100% exempt from IHT. The gifted value escapes the IHT net straight away.
3. Other tax-exempt transfers
There are several exemptions where there is no tax at the point of the gift, and the gifts are immediately outside the donor’s estate without having to survive seven years.
- An annual sum of up to £3,000. If not used in one year, it can be carried into the next year once, so long as the current year’s allowance is also used.
- Up to £250 each to as many people as you like or can afford.
- You can also give cash gifts for weddings or civil partnerships without paying tax. The limits depend on your relationship with the person receiving the money:
- If you are a parent, you can give up to £5,000.
- If you are a grandparent, you can give up to £2,500, as can any party to the marriage.
- Anyone else can give up to £1,000.
4. Give away any regular income that you don’t need
Each month, your total income may exceed what you spend. You are a regular net saver. The extra amount sits in your bank account unspent. If gifted, this surplus could qualify as ‘gifts out of surplus income’. The seven-year rule doesn’t apply.
There is no set limit on the amount that can be given away, provided the gift does not exceed your ‘surplus income’.
The qualifying conditions in order for the gift to fall within the exemption are as follows:
- The gift is made as part of your normal expenditure;
- taking one year with another, the gift is made out of surplus income (but not capital); and
- taken together with all the transfers that form part of your normal expenditure, you are left with sufficient income to maintain your usual standard of living.
5. Consider life insurance
If you do have surplus income, and are in good health for your age, consider insurance.
This doesn’t cut the IHT, but it does provide money to pay all or some of it. The insurance is in trust for your chosen beneficiaries. On your death, the claim is paid tax-free to your beneficiaries, who then use it to pay the IHT bill. This means that your surviving family get to keep most or all of what you have left behind.
6. Make a will
Having a solicitor prepare your will is a vital step in your IHT planning. Who you leave your estate to can make a difference to the inheritance tax bill. Usually, anything you leave to a spouse or registered civil partner is free from tax.
Don’t forget to have a current lasting power of attorney as well. There is no point crafting clever IHT planning if you later lose your mental capacity.
7. Top up your pension plan
If you still have an active personal pension or SIPP and can add money, it may be worth it.
You will qualify for income tax relief on your contribution. Once your money is in the pension (which should be protected by a trust), and you die before age 75, the entire pension pot can be inherited by your heirs tax-free. On death after age 75, your heirs can still inherit it free of IHT and only pay income tax on what sums they withdraw. Don’t forget to complete a death benefit nomination form so that the pension trustees know how to pass on the benefits.
8. Gifts that qualify for reliefs
The UK tax authority (HMRC) has allowed certain qualifying investments full or partial relief against IHT since 1976.
Business Relief and Agricultural Relief is available on qualifying assets at 100% or 50% once the asset has been owned by you for a full two years. If you invest in assets in the hope that they will qualify for relief from IHT, it isn’t without risk, of course. The underlying investments could fall in value as well as rise. And the tax rules may change.
For Business Relief you typically own shares, so even if you have invested, it is possible to dispose of the shares at a later date if you need to. This would mean the loss of the IHT relief.
9. Consider investing your ISA into AIM (Alternative Investment Market) shares
If you have a stocks and shares ISA already, you are invested in the ‘market’. On your death, your ISA value is included in the IHT calculation.
Since 2013 it has been possible to invest in AIM shares within an ISA. As in item 8 above, under current rules, qualifying AIM shares should benefit from IHT exemptions after two years.
The potential attraction of saving 40% IHT on some or all of your ISA can be offset by the risk profile of AIM shares.
10. Don’t discount the Discounted Gift Trust (DGT)
If you have spare capital which you won’t need later in life, but you require an ongoing income, a DGT may be worthwhile.
A trust is created, and you give property (money) to it, while retaining a right to a regular income for your lifetime (with the income level fixed at outset). You are allowed to withdraw up to 5% every year, based on the sum you invested with no immediate liability to income tax. You can’t ever have the capital sum back. The gift to the DGT is a PET or a CLT depending on the type of trust used.
You choose the trust beneficiaries, and they will inherit the money in the DGT on your death.
HMRC usually allow a discounted value on the gift you make into the DGT, because of the rights to income that you are keeping for your lifetime.
This discount means that once the trust is created and settled, any death thereafter (if a couple, then on the second to die) should result in a reduction of the IHT due.
An example may help: a married couple, husband aged 74 and wife 71, both in good health, invested £1m into a DGT and set the withdrawal rate at 5% (£50,000 a year). The discount factor was 64%, or £640,000. This would mean that only £360,000 of the gift would be accountable to IHT on death within seven years.
The rules and regulations of estate and tax planning can be complicated to navigate. Any errors made can be very costly and result in your heirs receiving less than you intended for them.
Seeking advice from your chartered financial planner when tackling your estate planning can be financially beneficial.
At Capital, we understand that supporting your family when you are no longer around can give you great peace of mind. If you would like to speak to one of our chartered financial planners about estate planning and minimising your inheritance tax bill, please click here to contact us.
- The value of your investments can go down as well as up, so you could get back less than you invested.
- The Financial Conduct Authority does not regulate estate planning, tax advice, wills or trusts.
- A pension is a long-term investment. The fund value may fluctuate and can go down. Your eventual income may depend on the size of the fund at retirement, future interest rates and tax legislation.