There are several straightforward ways to reduce the amount of IHT that is due.
Live seven years
Anything you give away at least seven years before your death is completely exempt from Inheritance Tax. So if you are healthy and you have substantial assets and you start giving them away in, say, your fifties or sixties, then as long as you live seven years from the date of the gift, no IHT will be due on that money.
Technically these are called Potentially Exempt Transfers or PETs, as they are exempt only if you live another seven years.
But, and there is a big but here, if you give something away and continue to use it, then it is still counted as part of your estate. For example, you might give your daughter a valuable painting but she lets you keep it hanging on your wall. A present like that is called a Gift with Reservation of Benefit or GROB. And it counts as yours, not hers, when your estate is taxed.
This rule applies equally to your home. So if you give your home to your children but you continue to live in it, then it is counted as your property, not theirs, when you die.
In theory, it is possible for you to live in the home without getting any ‘benefit’ from it if you pay your children a market rent. But they would then have to pay income tax on the profit from the rent and they would also have to pay capital gains tax on the rise in value of the home from when you made the gift to the time you die. So it is seldom a good idea.
There is one exception to this rule. If you give your home away to a relative, move out, but then have to move back either due to unforeseen circumstances or because you are unable to maintain yourself due to old age or infirmity, then its value may not form part of your estate. This rule is complicated and the Revenue will look carefully at any claims that make use of it.
There is another problem with giving things away. If you give away an object or an investment which is now much more valuable than when you acquired it – perhaps some shares you bought in the 1960s – then you may have to pay Capital Gains Tax on the growth in its value.
When you give it away, the tax is calculated as if you had sold it at market price on that date. So it is much simpler to give away cash.
If you die before the seven years are up and the gifts you made total less than the nil-rate band (the IHT threshold) when you die, then they are simply added onto your estate and tax is calculated on the whole amount. The people who have received the gifts have no responsibility to pay any of the tax due. It all comes out of the remaining estate.
However, if you make gifts within the seven years before your death and their total value is more than the nil-rate band (threshold) when you die, then tax will be due on the gifts – or some of them – and normally that will be paid by the recipient.
This article is an excerpt from Paul Lewis' guide to Taming Insurance Tax. Click here to download the complete guide for free.
Exempt lifetime gifts
Each year you can give away a certain amount and it will be exempt from Inheritance Tax, even if you die within seven years of making the gift.
You are allowed to give away a total of £3,000 each tax year without it counting towards the IHT arithmetic at all. And if you give nothing away in one tax year then you can bring £3,000 forward from that year and give away £6,000 the next tax year without running the risk of IHT being due on it, even if you die tomorrow.
If there is a wedding during the year then you can give up to £5,000 to a child of yours as a wedding gift – and up to £2,500 to a grandchild (or great-grandchild) or £1,000 to anyone else on their marriage. The gift has to be conditional on the wedding taking place.
You can combine these two exemptions. So you can give £5,000 to one of your children on their marriage and give them up to £3,000 as well.
Apart from these two big exemptions, you can give away any number of small gifts up to £250 each to any number of separate people. However, these recipients cannot also get money from you under any other exemption.
You can also give away some of your income free of tax. If you have a high income and can afford to give away part of it without reducing your own lifestyle, then that part is completely exempt.
For example: Alison Thomas inherited a good pension when her husband Denis died in 2005. She also has her own company pension and a state pension. Without Denis and as her age advances she does less and spends less. As a result her bank balance grows each month. She works out that she has at least £2,000 a year more than she needs and she could give that away without reducing her lifestyle. She already uses her full £3,000 a year for exempt gifts, which she shares each year between her two children, Charles and Mary.
She gives the £2,000 excess income in monthly instalments to her only granddaughter, Jade, who is a single parent and needs the money to pay for childcare. Alison is glad she can give this money to a younger member of the family rather than it accumulating in her bank and being liable for tax when she eventually dies.
If you make a gift using this rule, you should write a note explaining the arithmetic and keep it with your papers.
In some circumstances you can also pay money for maintenance without it counting as part of your estate.
There are three separate exemptions set out in Inheritance Tax Act 1984 s. 11.
- Gifts to your ex-spouse (or ex-civil partner) for their maintenance are exempt.
- Gifts to your children (but not grandchildren or other relatives) are exempt while they are in full-time education if the money is given for their maintenance or the costs of their education or training. So if a parent pays off a child’s student loan or pays their tuition fees, that payment should be exempt from IHT. Take care to pay it while they are still a student or at the very latest by the 5 April following the end of their full-time education or it may not be exempt.
- Gifts for the maintenance of any relative who is financially dependent on you are exempt.
All these exemptions are personal. So two parents can each give £3,000 a year and if they gave away nothing last year, they can give £12,000 this year between them, without it counting as part of their estate.
If they are married or civil partners, it doesn’t even matter if only one of them has the money – one can give the money to the other, who can then make the exempt gift with no tax consequences. That will usually be true of two unmarried individuals as well.
All these amounts are completely exempt from IHT however short a time you live after making them. Remember that if you live for seven years after making any gift, that is also completely exempt – subject to the Gifts with Reservation of Benefit rules as explained above.
A spouse who has inherited everything from their late husband or wife is not completely free to give that property away. If the person who has died left any instructions to make gifts out of the property and the survivor makes gifts according to those instructions within two years of the death, those gifts can be counted as if they had been made out of the estate. That would reduce the allowance available to be passed on when the widow eventually dies.
If you want your widow to pass things on after your death, it is safest to convey that information verbally and not to make it binding. Otherwise the gifts should not be made for at least two years after the first death. These rules are in the Inheritance Tax Act 1984 s.142.
There is no obligation to keep records of gifts – exempt or not – that you make while you are alive. However, there is an obligation on your executors to discover them all and to make sure the correct Inheritance Tax is paid. So it is very helpful to your executors – who will normally be your heirs – to keep a note of gifts that you make. If you think they are exempt gifts, explain why. Keep these documents with your Will or other papers so that they are easily found.
If the total value of your estate is below the IHT threshold, you can give away as much as you like without worrying. But remember, if you ‘deliberately deprive yourself of assets’ to avoid paying care fees, for example, or to claim other benefits, you can be treated as if you still own them when your entitlement to those benefits is assessed.
One final point on gifts. Never give away money that you need. It is your money, not your heirs’. You worked hard for it and you should benefit from it during your own life.
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Leaving money to charity
Anything left in your Will is completely exempt from Inheritance Tax if it is given to:
- A registered charity;
- A university;
- A national museum or art gallery;
- A political party which at the General Election before the death got at least two MPs elected to the UK Parliament or got one MP and at least 150,000 votes nationally. That rule applies to 11 political parties in the 2015 Parliament – the nine that have at least two MPs (Conservative, Labour, Scottish National Party, Liberal Democrat, Democratic Unionist Party, Sinn Fein, Plaid Cymru, Social Democratic & Labour Party, Ulster Unionist Party), as well as UKIP and the Green Party which each got one MP and more than 150,000 votes nationally;
- Any other body for ‘national purposes’. That phrase is explained in Schedule 3 of the Inheritance Tax Act 1984.
A new rule began on 6 April, 2012 that reduces the amount of IHT due on an estate if at least 10% of the taxable amount is given to a charity – but not to one of the other exempt bodies, unless of course it is also a charity.
The calculation is complicated.
Work out the taxable estate after deducting debts, etc, and then deducting the nil-rate band and, from 2017/18, the appropriate Residence Nil-rate band. That taxable estate is what HMRC calls the ‘baseline amount’. If the gift to charity is at least 10% of the baseline amount, then the balance after the gift to charity is taxed at 36%, not 40%.
For example: John expects to leave £500,000. His taxable estate is £500,000 - £325,000 = £175,000. Normally the tax due on that estate would be £175,000 x 40% = £70,000. But John decides to give £20,000 to a registered charity that rescues donkeys. That is more than 10% of his taxable estate, so after it is deducted the balance of £155,000 is taxed at 36% not 40%. The tax due is £55,800 instead of £62,000. His three children share £424,200 instead of £418,000. A gain to each of them of more than £2,000.
Giving money to charity may be a laudable thing to do. However, it should be done for its own sake not as a way to avoid tax. Even with the new rules, your heirs will be better off if you leave everything to them.
For example: If John had not given the money to the donkey charity, his children would have shared £430,000. A gain to each of more than another £1,900.
There is one exception to this general rule. If you planned to give some money to charity already but too little to get the 36% rate and then you raise that to the amount or a little more than is needed to get the 36% rate, you may find that your heirs will get more money from your estate. The arithmetic is very complicated and you should seek advice before considering such a move.
This charity relief applies only to a death that occurred on or after 6 April, 2012. It can be complex to work out. For more details see here.
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Major changes in the rules on the inheritance of pensions came into force on 6 April 2015. Put simply, if you have a pension fund and you nominate your heirs to get the money if you die before you use it, they will receive the whole amount tax-free.
If you are under 75 when you die, they can take the cash out and pay no tax. If you are 75 or more then they can keep the money in a pension fund of their own. Or they can take it out in cash or draw it out as an income. Either way it will be added to their income and taxed as such.
Beware of trying to move money into a pension to avoid IHT. HMRC may try to say that was deliberate avoidance and treat the pension money as if it was part of your estate, especially if you die within two years of moving the money. There are also strict rules about how much you can put into a pension in a year.
Ask your pension provider about nominating your heirs and seek financial advice if you want to make a large contribution into a pension.
If you have a life insurance policy that pays out on your death, the money will normally form part of your estate.
In all these cases, you can usually avoid IHT being due by making the policy ‘written in Trust’. That means instead of going directly to your dependants the money is paid into a Trust, which then passes it on to your dependants. That two-step process avoids the proceeds counting as part of your estate. However, this arrangement is slightly more difficult following recent changes in Trust law.
In the past, the proceeds would be paid into what is called a ‘discretionary Trust’ where the trustees decide who to pay the money to and when. They will be employees of the insurance company and will follow your request set out in what is called a ‘letter of wishes’.
If such a discretionary Trust was written before 22 March 2006, then the arrangement works and no tax is due. But if the discretionary Trust was written after that date and the value of the policy is more than £325,000, then a tax charge of 20% of the excess will be made when the policy is transferred to the Trust. If the trustees do not pass over the money to the heirs at once, then every ten years another charge of around 6% on the excess over the nil-rate band (threshold) will be due.
An alternative is to write the policy into what is called a ‘bare Trust’. With a bare Trust the trustees make no decisions – the policy belongs to the people named in the Trust, who would normally be your heirs.
Bare Trusts are not subject to any special tax regime – the money is taxed as belonging to the recipient. There would normally not be any tax due on the premiums you pay or the pay-out on your death.
Ask your insurance company or pension fund if your policy has been written in Trust; if it has not, ask how you can do so and make sure it is a bare Trust, not a discretionary Trust, if the value is likely to be more than £325,000. Some insurance companies may make a charge and some are less than helpful.
If you have considerable assets and want to give money away in the hope that you will live seven years, you can take out a specific life insurance policy that will pay the IHT due on your estate if you die within seven years. The policy should be a pure life insurance policy with no investment element and, of course, the proceeds should be written into a bare Trust. Such policies can be very cheap for people in their fifties but, of course, the older you get, the more expensive they become.
If you are one of a married couple or civil partnership, it is normally cheaper if the younger partner makes the gift and takes out the life insurance policy.
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If a person’s death was due to active service in the armed forces – or was hastened by it – then their whole estate is completely exempt from inheritance tax.
Many people can benefit from this little-known rule. It was used by the executors of the fourth Duke of Westminster in 1967. His family, one of the wealthiest in Britain, successfully claimed his death from cancer had been ‘hastened’ by a stomach wound he suffered fighting in France in 1944 and paid no inheritance tax at all. But many people of much more modest means can also benefit from this exemption, which has existed for more than 300 years.
The law is now section 154 of the Inheritance Tax Act 1984. If you think it may have applied to the estate of someone who has already died, you should apply to the capital taxes office for a refund of the tax – plus interest from when it was wrongly paid.
This exemption has now been extended to members of the emergency services and humanitarian aid workers who were on call helping during an emergency and that caused or contributed to their death.
The value of medals awarded for gallantry or for service is exempt from IHT when they are passed down through the family. The exemption does not apply to them once they have been sold.
The exemption used to apply only to medals awarded for gallantry or valour. But from 3 December 2014 it was extended to medals awarded for service in the armed forces, emergency services, and for achievement in public life awarded by the Crown or a foreign country.
How much inheritance tax will I be liable for?
Business Property Relief
Special rules apply to some shares and business property.
If a business or shares in an unlisted company are left by the deceased, then no IHT is due on them. That is called 100% Business Relief. Half the value of land, buildings, or machinery used in a business by the deceased is not subject to IHT. That is called 50% Business Relief. In both cases, the person who has died must have owned the property for at least two before they died.
If the person is a sole trader then the relief is only given if the business will carry on trading. Relief is not normally allowed on land or machinery used by the sole trader.
Some advisers recommend buying shares in unlisted companies – which also have other tax advantages – as a way of reducing Inheritance Tax. Like all shares, their value can go down as well as up. Such avoidance is generally for the wealthy.
Business Property Relief can be complex and you should seek advice from a qualified accountant. More information: www.gov.uk/business-relief-inheritance-tax/overview
Agricultural Property Relief
Some property defined as ‘agricultural’ is either 50% or 100% exempt from IHT. It includes a field where crops are grown, land where trees are grown and coppiced at least every ten years, or land which is not farmed under the habitat scheme.
In some circumstances farm buildings and dwellings on the land can be ‘agricultural’ as well. You normally have to own the land for at least two years before your death. A separate Woodland Relief can reduce the value of woodland and the wood on it which is inherited.
If you have spare resources and want to pass them on free of tax, buying exempt agricultural property can be one way to do it. Of course, you run the risk that its value will decline before it is inherited. The property can be in the UK, Isle of Man, Channel Islands, or the European Economic Area.
Agricultural Property Relief can be complex and you should seek advice from a qualified accountant before taking action or if you are an executor and think it may apply. More details at https://www.gov.uk/guidance/agricultural-relief-on-inheritance-tax
Wealthy families have used Trusts to avoid tax – and particular taxes on death – for centuries.
It is possible for people of more modest means whose heirs would face a hefty Inheritance Tax charge to use them too.
One technique favoured by many big insurance firms are ‘loan Trusts’. These arrangements are not risk free and, of course, cost money to set up and run. Unless your resources are considerable – in the millions – such things are best left to those with considerable wealth.
Some advisers will suggest you take out what is called an ‘equity release’ plan to reduce your liability to Inheritance Tax.
It works like this. You borrow money against the value of your home. While you are alive you normally pay no interest on the loan. When you die, the loan and any accrued interest is paid from the value of your home, which is therefore reduced and there is less in your estate and so the Inheritance Tax due is reduced or disappears completely.
Equity release might be a perfectly sensible way of raising money if you need more income or capital in retirement. And clearly taking out an equity release product will reduce the amount of your estate and the tax due. But that is a side effect. You should never embark on equity release just to reduce IHT. If you do not need extra capital or income, then equity release should never be considered. It is better for your heirs to have 60% of something than 100% of nothing.
When do I pay inheritance tax and how is it collected?
Some insurance companies and financial consultants have made a lot of money selling plans to reduce or avoid Inheritance Tax. Such schemes can be complicated – involving juggling the ownership of money or making gifts into or from Trusts – and often involve taking out an insurance policy.
These schemes are often designed principally to generate commission for the person who sells them. If the scheme does not work it is your heirs, not the adviser, who will end up paying the bill.
In 2005, the government clamped down on one kind of scheme, leaving 30,000 people, who had paid good money for advice, with a tax bill every year just to carry on living in their own home.
In 2006, major uncertainty was created when the government announced plans to change the way that Trusts were taxed, without any consultation. Later it watered down the proposals but the changes have made deals involving Trusts much less attractive.
The last Government warned that it will take action against any scheme that is set up just to avoid tax. In 2013, a new General Anti-Abuse Rule came into force that will make it even harder to set up cunning schemes to avoid tax. The present Government seems determined to continue in the same way.
So, generally, such plans are best avoided. If you want to consider one, then before you commit yourself make sure it has the positive approval of HM Revenue & Customs, and discuss it with an impartial professional adviser – such as a solicitor or accountant – whom you have found yourself and who is entirely separate from the company or individual selling the product.
This article is an excerpt. To read Paul Lewis' complete guide to inheritance tax, click here.