Can you avoid Inheritance Tax?
Everybody in the UK is liable for Inheritance Tax (IHT) if the size of their estate is greater than the basic threshold. This threshold is also known as the nil-rate band and is currently set at £325,000 (though this is likely to change in the future). The standard rate for Inheritance Tax is 40% of everything above the nil-rate band.
Even if your estate is valued above £325,000, it doesn't necessarily mean an IHT bill will be due when you die. Avoiding Inheritance Tax, or at the very least reducing the amount payable, is possible through effective estate planning.
Tax treatment depends on your individual circumstances and may be subject to change in future.
Ways to reduce Inheritance Tax
It's possible to reduce the amount of Inheritance Tax due when you die, so you can leave more to your loved ones. Methods include:
- Leaving your estate to a spouse or civil partner
- Setting up trusts
- Gifts to charity
- Lifetime gifts
- Using life insurance
The guide will cover these and more, helping you to decide whether any are suitable for downsizing your own potential IHT bill.
Making a will to distribute your assets
Making a will is an important part of estate planning. Firstly, it's the only way to ensure your estate is distributed in accordance with your wishes. Secondly, it can be used to provide a legal framework outlining tax efficient methods to potentially reduce an IHT bill.
Whether leaving assets to a spouse or civil partner, distributing assets to take advantage of tax-free allowances, or making gifts to charity, a valid will could help you to reduce or avoid Inheritance Tax altogether.
Speak to a specialist in estate planning beforehand, to ensure you are structuring your will to make the most of the relief available to you.
Please bear in mind that advice in relation to Inheritance Tax planning is not regulated by the Financial Conduct Authority.
Using the Inheritance Tax spouse exemption
The simplest way of avoiding Inheritance Tax is via the spouse or civil partner exemption rule. This covers couples who are either legally married or in a civil partnership. It also covers partners who are separated, but not those who are divorced (or had their civil partnership dissolved) at the time of death.
The exemption means that you can leave your entire estate to your spouse or civil partner and even if its value exceeds the nil-rate band of £325,000, there'll be no Inheritance Tax to pay.
Your surviving spouse or civil partner can also 'inherit' your unused nil-rate band, which could effectively double their own threshold, allowing them to leave an estate of up to £650,000 before IHT becomes payable.
The transferal of your unused nil-rate band must be requested by the legal representatives of your spouse or civil partner, once they too have died.
Using trusts to reduce Inheritance Tax
Transferring assets into a trust can help to reduce your Inheritance Tax bill. Once the asset is held in trust, it is administered by a trustee or a group of trustees on behalf of whoever stands to benefit from it.
The asset or assets will no longer be part of your estate and therefore not considered when valuing your estate for IHT purposes. This is providing you live for at least seven more years after placing the assets into trust. You can find out more about the seven-year rule below.
Before placing money or other assets into trust, you should be aware of the implications involved. It is best to consult an expert on these matters before making any decision.
You can learn more about trusts and how they work in our guide to trusts.
Inheritance Tax and gifts to charity
If you leave a gift to a qualifying charity in your will, whether it's money, property or another asset, it will be exempt from Inheritance Tax. This is one way of reducing the size of your estate and lowering the amount of IHT owed when you die.
You can also reduce the 40% rate of Inheritance Tax through charitable gifts. If you leave at least 10% of the net value of your estate to charity (which is everything in your name, minus debts, funeral expenses and any other IHT exemptions), what remains above the threshold will be taxed at the reduced rate of 36%.
In certain cases, where the value of the gift or gifts to charity falls below the 10% threshold, the beneficiary of your estate may be able to top it up so that the reduced IHT rate becomes applicable.
Whether this is possible may be dependent on individual circumstances, such as conditions in your will, or the consent of other beneficiaries.
Inheritance tax on lifetime gifts
A common way to avoid Inheritance Tax, or reduce the amount eventually payable, is to give money or assets to the beneficiaries of your estate while you're still alive. This will not only reduce the value of your estate once you die, but also help the assets reach your loved ones tax-free.
A lifetime gift will fall into one of the following three categories:
- Exempt transfers – These are gifts, usually below a certain amount, that can be made at any time and aren't liable for Inheritance Tax.
- Potentially exempt transfers – A gift that doesn't meet the exemption criteria of an exempt transfer, but will not be considered for Inheritance Tax if given seven or more years prior to your death (see below).
- Chargeable lifetime transfers – A gift that is neither exempt or potentially exempt and, where the nil-rate band is exceeded, liable for Inheritance Tax.
These categories are looked at in more detail in our guide to Inheritance Tax planning.
One of the key considerations when deciding whether a gift is subject to Inheritance Tax, is the seven-year rule.
What is the seven-year rule in Inheritance Tax?
The seven-year rule states there is no Inheritance Tax due on certain gifts (potentially exempt transfers) given to a second party seven or more years before you die.
If you die within seven years of making the gift, the amount then becomes part of the valuation of your estate and, excluding any exemptions, will be taxable if the threshold is exceeded. In these circumstances the beneficiaries of the gifts are responsible for paying the tax.
How soon you die after making the gift affects the rate of IHT charged. This is known as taper relief. It applies only to the amount of tax payable on the value of the gift above the nil-rate band. The remainder of the estate eligible for Inheritance Tax will be subject to the standard rate (40%).
The table below sets out the taper relief rates:
| Time between gift/transfer and death | IHT rate on gift/asset |
|---|---|
| Up to 3 years | 40% |
| 3 to 4 years | 32% |
| 4 to 5 years | 24% |
| 5 to 6 years | 16% |
| 6 to 7 years | 8% |
| 7 or more years | 0% |
Personal pensions and Inheritance Tax
A personal pension plan can usually be passed on outside of your estate. Therefore, it is possible to leave your remaining pension pot to a beneficiary without it incurring Inheritance Tax.
Most personal pensions allow you to nominate a beneficiary, who will receive the remaining value of your pension when you die. Dependent on the type of pension and the age at which you die, the recipient may still be subject to tax on any income the pension generates.
If you have taken money from your pension pot, as part of income drawdown for instance, and it's sitting in your bank when you die, this may be considered part of your estate and liable for Inheritance Tax.
Defined benefit pension schemes have their own rules. For more information, you can read What happens to my Teachers' pension when I die? or What happens to my NHS pension when I die?
Using equity release to reduce Inheritance Tax
Home equity refers to how much of your home you own outright (its value minus the remainder of what you owe). Equity release is a financial product that allows you to access the value tied up in your home without having to sell it. This is paid out in the form of tax-free cash.
Equity release will reduce the value of your estate, as your home will be sold after you die to repay the amount borrowed (plus interest). If you choose a joint plan with your spouse or civil partner and they survive you, the property will be sold once they die or move into long-term care.
This can reduce the amount of Inheritance Tax payable, but it will also reduce the amount you are able to pass on to your loved ones.
There's also the possibility that if you go on to live for a long time after releasing equity in your home, the interest payable may be more than you would've owed in Inheritance Tax.
Equity release is a big decision. It isn’t right for everyone and will reduce the value of your estate, which is why it’s important to explore all of your options.
Wesleyan Financial Services does not provide advice on equity release. However, you can speak to one of our Specialist Financial Advisers who can review your personal circumstances and explore alternatives.
Using life insurance to pay Inheritance Tax
A life insurance policy can potentially cover all or part of an inheritance Tax bill.
A whole-of-life insurance policy pays out on death and, if it was held in trust and didn't fall under the seven-year rule, wouldn't be considered part of your estate for IHT purposes.
As you have set up the policy specifically to settle any IHT bill, the 10-year anniversary charge shouldn't apply. This rule sees Inheritance Tax payable every 10 years after a trust is set up.
If you choose to use a life insurance policy to cover Inheritance Tax, you will need to be sure that you keep the premiums up to date and that there'll be enough in the pot to pay off the bill when you die.
Other IHT reliefs
There are other reliefs available, which can help to reduce an Inheritance Tax bill. These include:
- The residence nil-rate band – If you leave your home to a direct descendant, adopted child, foster child or stepchild, and the total value of your estate is less than £2 million, your IHT threshold could increase to £500,000.
- Leaving the excess to a Community Amateur Sports Club – If you leave everything above the nil-rate band to a HM Revenue & Customs (HMRC)-registered Community Amateur Sports Club (CASC), there'll be no Inheritance Tax to pay.
- Business relief – It is possible to claim a relief that can reduce the value of a business or the assets it holds when evaluating an estate for Inheritance Tax purposes.
- Agricultural relief – Another form of IHT relief that can be claimed against the transfer of agricultural property.
One final and simple way of reducing the value of your estate is to spend some of your money on yourself. Speak to a Specialist Financial Adviser from Wesleyan Financial Services. They can help you to plan how much you'll need to enjoy your later years to the full, while still leaving something for your loved ones.