With some smart estate planning, there are a number of ways you can reduce your inheritance tax liability. Our latest blog explains how you can ensure more of your estate is left to loved ones rather than paid out in tax.
The Office of Budget Responsibility has estimated that HMRC inheritance tax takings are set to raise to £37 billion over the next five years.
This is a big jump compared to £26.7bn for the previous five years and is said to be driven by inflation and the freezing of the thresholds at which inheritance tax becomes payable.
This means that more people, and more of their wealth is going to get drawn into the scope of inheritance tax.
The good news is that there are numerous planning strategies for managing inheritance tax liability. With some smart planning, many people will be able to take themselves out of its scope completely, or at the very least reduce its impact significantly.
What’s the current inheritance tax threshold?
The standard rate of inheritance tax is 40% but there are a number of allowances and exemptions which can help to reduce this.
The most significant of these is your inheritance tax allowance, known as the nil-rate band. This allows the first £325,000 of your estate to be paid free from inheritance tax.
There is an additional nil-rate band for your primary residence of £175,000 if you leave it to direct descendants (including adopted, foster or stepchildren). Your total net estate must be valued at less than £2 million in order for this to apply. Above this, the additional nil-rate band will be tapered away by £1 for every £2 exceeded.
Furthermore, inheritance tax is not payable on anything left to a spouse or civil partner. They can carry over your unused allowances, meaning a married couple (or rather their beneficiaries) enjoy a £650,000 inheritance tax allowance, or £1 million if the primary residence nil-rate bands are also available.
Anything left to charities or community amateur sports clubs is also exempt from inheritance tax.
Giving gifts
Gift giving is another effective tactic for reducing inheritance tax liability.
There are some smaller scale gifting options including:
- Weddings (up to £5,000)
- Annual gifts (up to £3,000)
- Small gifts (up to £250 per person per year)
The bigger opportunity potentially comes from regular gifting and utilising the seven-year rule.
Normally, if you give money away within seven years of your death and it does not fall within one of the above gift exemptions, it’s treated as if it remains within your estate for inheritance tax purposes.
However, regular gifting rules say that if you gift money regularly out of your normal income after you have met all your own living costs, there’s no limit to how much you can give tax-free.
The seven-year rule for non-income based gifts is a bit more involved. It refers to a taper system where the inheritance tax liability on a gift reduces in the years after you give it. If you survive for seven years, the liability reduces to zero, no matter the gift’s value.
The tapering reduces the tax rate as follows:
- Zero to three years – 40%
- Three to four years – 32%
- Four to five years – 24%
- Five to six years – 16%
- Six to seven years – 8%
- Seven or more years – 0%
To qualify, you must give the gift without reservation. This means you have no right over the gift and cannot benefit from it unless you’re paying a market value.
If you gift a house for example, you cannot live in it unless you were to pay rent. If you gifted a painting, you couldn’t continue to hang it on your wall. If you gifted money, you would have to make clear that it’s not a loan which you expected to be repaid.
Other than this, there’s no limit. As part of a long-term strategy, gifting is a highly effective way to reduce inheritance tax liability.
Making a will
While a good gifting strategy can help your estate sidestep inheritance tax while you’re still alive, a will can help your estate manage the liability after your death.
This provides you with an opportunity to specify exactly how your estate is divided after you die. While the primary driver of this is usually to ensure assets go to the right people, there can be unwelcome tax consequences if you don’t have a will.
Without a will, your estate is subject to intestacy law. This is highly prescribed, and often, assets are not distributed how you might imagine. We’re focussing on estate planning here, so won’t go into detail about the family arguments that might arise as a result.
To illustrate one consequence of intestacy, your spouse may not automatically get all your estate without a will in place – even if you wanted them to.
Intestacy says that a spouse gets all the personal belongings plus the first £270,000 of the estate. Then, if there are surviving children, the excess of the estate above £270,000 is split – with 50% going to the spouse and 50% to be shared equally amongst the children (including those from previous relationships if applicable).
Because any estate left to a spouse is not subject to inheritance tax, intestacy could yield a tax bill where none needed be due if it diverted assets away from a spouse.
Other considerations
We’ve already mentioned that anything left to charities is exempt from inheritance tax. It’s also possible to pay a reduced rate of 36% inheritance tax on some assets if you leave at least 10% of the net value of your estate to a qualifying charity.
For some people, a life insurance pay-out may be made and become part of their estate. This could then be significantly reduced by inheritance tax. There is a simple way to avoid this, which is by making sure the life insurance policy is written in a trust.
Most insurers give you the choice automatically when policies are taken out, so you can check if this was selected. Even if it wasn’t, you can put a policy into trust at any time, although you may need professional help.
Finally, consider that pensions can in some cases be passed on to beneficiaries without being subject to inheritance tax. This is not the primary purpose of a pension and they are subject to complex rules, but it may be useful to know for some.
If you would like further help or advice about estate planning, please don’t hesitate to get in touch with PKB.
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