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How to pay less inheritance tax

Paul Lewis / 30 June 2022

Are you unsure about the latest inheritance tax rules? Our expert explains how it works and the best ways to pay less or avoid it.

Family tree illustration
Image by Neil Webb

The Treasury is taking more and more inheritance tax every year. A combination of rising house prices – for most people their major asset – and allowances which have been frozen since 2009 means a growing number of estates are dragged into the inheritance tax net. I don’t want to overstate it – 15 out of 16 estates still pay no inheritance tax at all – but it is estimated that nearly 40,000 estates will pay £6.7 billion this year and that will grow to more than 45,000 paying £8.3 billion in 2026/27.

Two things you should not do. First, do not pay money to schemes that say they will hide your home from the taxman, normally by putting it in trust and taking out insurance. They are expensive and probably will not work.

Second, do not give your home away to your children and continue to live in it. That is known as a gift with reservation of benefit (GROB). You still benefit from living in your home and the Revenue will count its value as part of your estate. You can avoid the GROB trap if you pay a market rent to live there. But that will cost a lot and the people you give it to will have to pay tax on the amount they receive.

They will also be liable for capital gains tax on the rise in its value from the time you gave it to them to the day they sell it. They will own your home and could make you move out. However unlikely that seems, if one of them goes bankrupt or gets divorced the value of their share of the home would be counted as an asset and the courts could force them to sell it.

Is Equity Release right for you? Find out more here

Get married

If you leave everything to your spouse or civil partner, then no inheritance tax is due. This rule does not apply to partners who just live together, however long they have been an item. If you know you are dying you can arrange an emergency or death bed marriage. The comedian Ken Dodd did that in 2018 saving his companion of 40 years, Anne Jones, an estimated £11 million in inheritance tax. Call the local register office and it will arrange a wedding quickly in your home or hospital.

Otherwise, the first £325,000 of your estate is free of tax and if you leave your home to a direct descendant there is an extra allowance of up to £175,000 – called the residence nil rate band – added to the £325,000. It cannot be worth more than the house you pass on. A ‘direct descendant’ is your child or children, a grandchild or great-grandchild. Step, adopted or foster children are included but not nephews or nieces, cousins, siblings, or anyone else. If your estate is worth more than £2 million the residence allowance is reduced and disappears at £2.35 million (£2.7 million for a surviving spouse’s estate).

If you are a widow or widower (or surviving civil partner) and your beloved left everything to you then both these allowances are doubled when you die. So, the first £650,000 you leave is free of tax and the value of your home up to £350,000 will also be ignored. So, if your home is worth at least that much, you can leave £1 million to your children free of inheritance tax. Any amount left to charity is exempt.

The main threshold of £325,000 has not risen since 2009. If it had increased with inflation, it would now be almost £440,000.

Give it away

During your lifetime you can make gifts out of savings or investments which reduce your estate and limit the tax due. If you live seven years after you make the gift, it is not counted in the tax calculation. Even if you die sooner than that you can give away up to £3,000 each tax year. This £3,000 is the total you can give, not the gift per individual, so three gifts of £1,000 uses it up. If you gave nothing last tax year you can bring that allowance forward and give away £6,000 this tax year. You can also make a wedding gift up to £5,000 to a child of yours or £2,500 to a grandchild or great-grandchild, or £1,000 to anyone who gets married.

'If these allowances had risen with inflation the £3,000 limit would be more like £12,000'

These allowances are all personal, so partners can give away that much each. If necessary, spouses can transfer money between them tax-free to make the gifts. You can also give away small amounts up to £250 each to any number of individuals – though not to the people who have been given the bigger gifts. It is best to give money rather than shares, investments or valuable objects, as capital gains tax may be due when they are given.

These allowances have not changed since 1981. If they had risen with inflation the £3,000 limit would be more like £12,000 now and the £250 around £1,000.

Finally, you can give away your surplus income up to any amount as long as it does not reduce your lifestyle. This little-known rule can be helpful, for example, to a widow who has inherited a pension which gives her a bigger income than she can spend. But it can be used by anyone whose income is higher than their expenditure, perhaps as they get older and spend less. The gifts should be regular or at least periodic and part of a pattern.

It will help your executors if you note down any gifts you make and why you believe them to be exempt from inheritance tax so they can be comfortable leaving them out of your estate.

This is only a brief guide. If you expect to leave significant amounts, you should ask a qualified accountant for advice.

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The opinions expressed are those of the author and are not held by Saga unless specifically stated. The material is for general information only and does not constitute investment, tax, legal, medical or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.