Inheritance Tax

How to reduce an inheritance tax bill

How inheritance tax works
Why you need an up-to-date will
The value of gifting assets during your lifetime
The most tax-efficient form of home ownership
How pensions can be used as an estate planning tool
The benefits of using trusts
When Business Relief and Enterprise Investment Schemes could be appropriate.

Inheritance tax raised a record £4.9bn in the last financial year [1], the highest amount since the current tax system was introduced 31 years ago.

This is more than double the annual amount paid in inheritance tax (IHT) in the 2009-10 tax year, when IHT netted £2.3bn.[1] The dramatic increase in the IHT haul in recent years has mainly been the result of rising property prices and frozen tax thresholds - but, it is also a consequence of many families failure to plan.

Why you should consider IHT Planning

Whenever someone dies the value of their estate becomes liable for IHT. If you are domiciled in the UK, your estate includes everything you own, including your home and certain trusts in which you may have an interest.

However, everyone is entitled to pass on assets of up to £325,000 free of IHT.

This is called the nil-rate band. Married couples and registered civil partners can share their thresholds, transferring the unused element of their IHT-free allowance to their living spouse when they die. Doubling up the relief means a married couple or registered civil partnership have a joint nil-rate band of £650,000.

The New Residence Allowance

In April 2017 an extra allowance was introduced when a residence is passed to a ‘direct descendant’. This is known as the residence nil-rate band (RNRB), and like the standard nil-rate band unused elements of the allowance are transferable to a surviving spouse or registered civil partner.

In the 2017-18 tax year, the RNRB is £100,000 per person. This means a married couple with children can pass on a maximum of £850,000 in total without having to pay IHT – two lots of £325,000 (£650,000) and two lots of £100,000 (£200,000).

Any excess over this amount is then taxed at 40%.

The RNRB will rise in steps to £175,000 in April 2020, at which point couples will be able to leave up to £1m tax free when they die.

The Voluntary Tax

On top of the nil-rate bands there are a range of reliefs and exemptions that with careful planning can be used to reduce an IHT bill.

More than a third of people (36%) don’t feel comfortable talking about their legacy
One in seven (14%) said they haven’t discussed the subject with loved ones because they don’t like talking about death
A health scare (52%), a near death experience (46%) and getting older (46%) are most likely to prompt people to talk to loved ones about this important subject
After their partner and spouse (32%), people feel most comfortable talking to their mother (8%) or a financial adviser (8%) in the first instance.

Making estate planning work for you

Step 1: First, Think Will

Before you move on to any other forms of estate planning it is essential that you have an up-to-date will. Making a will is one of the most important things you can do to ensure your estate goes to who you want and that your wishes are carried out.

Even if you already have a will you might need to take action. For example, you might need to revisit your will to benefit from the residence nil-rate band. The new relief will only be available if assets are left directly to descendants. As a lot of older wills hold assets in trust you could lose out if your will is not updated.

Take legal advice to make sure your wishes are met and your wills are as tax-efficient as possible. Many people set up mirror wills with their spouse, which means that they leave their estate to the other in the event of their death. However, it might make more sense to make a will that transfers some assets to children or grandchildren after the death of the first spouse. It depends on your circumstances.

Step 2: Lifetime gifts start with the simple things

Most people wait until death before passing on their wealth through their wills. However, it can be more tax-efficient for IHT purposes to gift money while you are still alive.

Transferrring wealth while you are alive can have a transformative effect on both your and your family’s life. Gifting money to a younger relative to top up their pension can substantially boost their income when they eventually retire. And paying into an ISA for a youngster can provide them with a useful financial head start in life. Half of people say that their main incentive for making lifetime gifts is a desire to watch loved ones benefit from their wealth. [3]

Each year you can give away £3,000 and that gift will not be subject to IHT.
You can also give £250 to any number of people each year.
Parents can give £5,000 to each of their children as a wedding gift. Grandparents can give £2,500 and anyone else £1,000.

Gifts of any size to charities or political parties, are also tax free. If a gift is regular, comes out of your income and does not affect your standard of living, any amount of money can be given away and ignored for IHT.

It is possible to make further tax-free gifts – potentially exempt transfers – but you have to survive for seven years after making the gift to get the full benefit of it being outside of your estate for IHT purposes.

If you pass away within seven years and the gifts are valued at more than the nil-rate band, taper relief will be applied. The tax reduces on a sliding scale if the gift was made between three and seven years earlier.

Step 3: Consider how you own your home

Typically, couples own their home as joint tenants. If one partner dies, the other automatically becomes the sole owner of the property.

This works for many couples, but for some it makes more sense to be tenants in common. This means they each own a set share of the home. This can be half each, or a defined percentage. This enables each partner to pass on a share of their home on death to someone other than their spouse – their children, for instance.

This can help reduce an IHT bill and long-term care costs. However, it’s a complicated decision, so you should seek advice from legal and tax experts before changing the way you own your home.

Step 4: Make use of your pensions

Pensions are one of the most tax-efficient ways to pass on your wealth. If you pass away before the age of 75, benefits left in a money purchase pension can be paid as a lump sum or drawdown income to any beneficiary, with absolutely no tax to pay. After the age of 75 they will be taxed at the beneficiaries’ marginal income tax rate. [4]

It might make sense to use other investments, such as individual savings accounts, to provide a retirement income and retain funds in your pension for as long as possible.

As long as the funds remain in drawdown they will remain IHT free. This means you can pass your pension on to your children, and then they can pass it on to their children who in turn can pass it to their offspring, raising the prospect of pension money cascading down the generations.

Step 5: Take control with trusts

Trusts can reduce an IHT bill and give you control over how your assets are used by future generations.

Trusts can help you:

Keep a lump sum outside of your survivor’s estate to ensure it is not subject to IHT
Protect your children/grandchildren’s legacy if your surviving spouse remarries
Protect your children/grandchildren’s legacy from their own marital disputes
Avoid giving children/grandchildren a sum of money that they may not spend as wisely as you would like.

Trusts can be a complex matter. For example, if you die within seven years of making a transfer into a trust your estate will have to pay IHT at the full amount of 40%. [5]

We can make a referral to a legal professional to assist you.

Step 6: Don't forget life assurance

Life assurance can be used to either meet or reduce a prospective IHT bill. You set up a whole-of-life assurance policy, which lasts for as long as you live.

As long as the policy is written in trust, the proceeds of the life assurance policy will not be included in your estate. When you die the policy pays out to the trust which pays all or part of the inheritance tax bill.

Step 7: Think about discounted gift trusts

An alternative option, if you can give up capital, is a discounted gift trust. These are designed for people who want to gift money to a trust, draw a regular income for the rest of their life and then pass what is remaining of the gift to their heirs free of IHT.

The trust purchases an investment bond, which provides a tax-efficient income of up to 5% until your death. If you survive for seven years, the bond does not count as part of your estate.

Even if you died within seven years your heirs would receive a discount on the IHT because your right to draw an income from the gift reduces its value.

Step 8: Further planning opportunities

A number of shares listed on the Alternative Investment Market, or AIM, become free from IHT once you have held them for two years because they qualify for Business Relief (BR).

You need to take care as there are strict rules on what qualifies and investing in AIM stocks can be risky. However, we can recommend schemes that have a track record of managing successful portfolios of assets that qualify for BR.

Enterprise Investment Schemes (EISs) also benefit from BR, meaning there is no IHT to pay on investments once you have held them for two years.

EISs, which invest in small, high-risk unquoted enterprises, offer a number of tax advantages. There is upfront income tax relief of 30%, and, provided the investment is held for three years, there is no capital gains tax to pay when the EIS is eventually sold.

If capital gains on another asset are realised, the tax can be deferred by reinvesting them in an EIS. If the EIS is held until death, the deferred gain is wiped out and never chargeable.