Inheritance tax, often dubbed the “death tax” is a looming spectre for many families, threatening to diminish the wealth they’ve worked so diligently to accumulate. However, contrary to popular belief, Inheritance Tax is not an inevitable burden. With strategic planning and foresight, it’s possible to mitigate its impact on your estate. A successful estate plan can even lead to no tax being due on your financial legacy.
Planning for the future isn’t just about retirement savings and living comfortably in your golden years. It’s also about making sure your hard-earned wealth smoothly reaches the people you want it to after you’re gone. This is where Inheritance Tax (IHT) comes in because it plays a significant role in determining how much your loved ones ultimately inherit.
In this guide, we delve into some of the intricacies of IHT in the UK. It will equip you with essential knowledge to engage in effective estate planning and minimise tax liabilities.
But why does Inheritance Tax planning matter?
Beyond the tax implications, effective estate planning is about preserving your legacy and ensuring your loved ones benefit from your wealth in a way you’re comfortable with. By taking proactive steps to minimise your tax liabilities, you can also maximise the impact of your wealth – and leave behind a legacy that reflects your values and aspirations. Giving your beneficiaries as much as possible helps take care of the next generations.
DEMYSTIFYING IHT: THE NUMBERS AND REGULATIONS
Inheritance Tax is levied on the net value of your estate (assets minus debts) exceeding the tax-free threshold called the “nil rate band” (NRB) when you die. In the UK, the standard tax-free amount is currently £325,000 per individual. Anything above this threshold is subject to a standard tax rate of 40%. However, some additional allowances and exemptions can significantly reduce the taxable amount.
For instance, the “residence nil rate band” (RNRB) allows homeowners to pass on up to an additional £175,000 tax-free if their main home is left to direct descendants and certain other conditions are met. This can increase the combined tax-free threshold to £500,000 for individuals who own their home. The thresholds are also transferred between married couples or civil partners who leave their entire estate to each other. That means a property-owning married couple could leave up to £1 million to the next generations of their family before paying any Inheritance Tax. Just be aware that the RNRB is “tapered” away by £1 for every £2 an estate exceeds a £2 million threshold. Effective financial planning can help prevent that happening.
Giving 10% or more of your estate to charity in your will can also reduce the rate of tax to 36%.
Understanding the latest figures paints a clearer picture of IHT’s impact. According to HM Revenue & Customs (HMRC), Inheritance Tax receipts in the UK reached a record high of £7.1 billion in 2022/23. That represents a 15% increase from the previous year. The rise may be attributed to things like increasing property values and tax thresholds being frozen since 2009/10 (when inflation was considerably lower than it is now).
ESTATE PLANNING ESSENTIALS: LAYING THE GROUNDWORK
Navigating the IHT landscape requires strategic planning. Here are some steps to consider:
Identify beneficiaries: Clearly specify who you want to inherit your estate and in what proportions. Consider using gifts and trusts strategically to reduce the taxable amount.
Create a will: It’s the cornerstone of estate planning because a will clearly outlines your wishes for how the executors should distribute assets. A well-drafted will can minimise the chances of family disputes and ensure your intentions are followed. If you die without a correctly drafted will in place, the beneficiaries you identified may not get what you wanted.
Know your assets: Compile a detailed inventory of your assets, including property, investments, savings, and possessions. Understanding the total value is crucial for determining potential tax liabilities. It can also save your executors time and money trying to work out what you owned.
Seek professional advice: Consulting a qualified financial adviser who is experienced in IHT planning can provide invaluable guidance and tailor strategies to your unique circumstances. They can also pinpoint any shortcomings in your provision and signpost you to the right legal and accountancy experts where necessary.
SMALL BUT MIGHTY: TACTICAL CONSIDERATIONS
Even seemingly minor actions can impact your IHT bill:
Gifting: There are annual allowances for gifting money/assets to people without incurring any tax. Using your allowances and making regular gifts from surplus income can gradually reduce the value of your taxable estate. Beyond the amounts you can give away each year, there’s no limit to how much you can gift tax free if certain conditions are met – known as the “normal expenditure out of income” rules. Other, larger, gifts can also be an effective way to reduce your estate. These will usually be covered by the infamous “seven-year rule”, which is complex. There’s a lot to consider when making gifts so it can be difficult to get your gifting strategy right. It’s therefore important to take professional advice and keep detailed records.
Pensions: Contributing to pension plans can reduce your taxable estate as funds are generally exempt from IHT when passed onto beneficiaries. Just remember pension regulations can be complicated so take advice about the best option.
Business Relief: Business owners can benefit from significant IHT relief by owning assets that qualify for Business Relief. This tax relief reduces the value of a business or its assets (by 100% or 50%) when working out how much Inheritance Tax must be paid. Some types of higher-risk retail investment (like shares in an unlisted company) can also qualify for Business Relief, so this option isn’t limited to entrepreneurs. To qualify for Business Relief, the deceased must have owned the business or asset for at least 2 years.
MINIMISING LIABILITIES: SMART STRATEGIES FOR REDUCING IHT
While IHT can seem daunting, several strategies can minimise its impact:
Utilise tax-free allowances: Take full advantage of the main tax-free threshold and residence nil-rate band by distributing your assets within these limits.
Implement charitable giving: Leaving 10% or more of your estate to registered charities reduces the headline rate of IHT to 36%.
Explore Business Relief: If you own a business, ensure you meet the eligibility criteria for Business Relief, which can significantly reduce your IHT position. Investing in certain smaller companies can achieve the same effect, although this type of investment is higher-risk, and you should be prepared to lose your capital.
Leverage spousal allowances: Married couples or civil partners can transfer unused tax-free allowances to their surviving partner. If all allowances are transferred, that effectively doubles the threshold available on second death.
Use trusts: Trust structures can be used to manage assets and reduce IHT liabilities, with some degree of flexibility and/or control. You need to take appropriate legal advice before setting up any trusts.
GIFTING STRATEGIES: SHARING FOR THE FUTURE
Making strategic gifts can be an effective IHT planning tool. However, you’ll need to navigate the various rules and regulations:
Annual exemption: You can give up to £3,000 worth of gifts each tax year without them being added to the value of your estate.
Gifts for weddings or civil partnerships: Each tax year, you can give someone who is getting married or starting a civil partnership a tax-free gift. There are limits to how much you can give tax-free depending on that person’s relationship to you.
Small gift exemption: Unlimited gifts of up to £250 per person can be made each tax year, as long as you haven’t used another allowance on them.
Regular gifts: You can make regular gifts out of your income if they don’t affect your standard of living. You must be able to provide this so keeping accurate records of any gifts made is crucial.
Larger gifts: Higher value gifts that exceed these exemptions can also escape Inheritance Tax. No tax is due on any gifts you make if you live for seven years after giving them away. This is known as the “7-year rule” and is a complicated piece of tax law to navigate so it’s important to take professional advice before using it.
IMPORTANT INFORMATION
Planning early and seeking professional guidance are essential for maximising your legacy and minimising the impact of IHT. Consulting a qualified financial adviser will ensure your estate plan is personalised and strategically aligns with your goals and circumstances.
Taxation depends on individual circumstances as well as tax law and HMRC practice - which can change.
The Financial Conduct Authority (FCA) does not regulate Inheritance Tax Planning, tax, or trusts.
The value of investments can go down as well as up and you may not get back the full amount you invested. The past is not a guide to future performance and past performance may not necessarily be repeated.
Information contained within this article is for informational purposes only and does not constitute financial advice. Its purpose is to provide general guidance.