Your guide to inheritance tax – from what it is to how to reduce it

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  • Who pays inheritance tax?
  • Married couples are ahead in the inheritance game
  • Beating inheritance tax is in your gift
  • A word of warning
  • Max out your annual IHT-free gift allowances
  • Consider setting up a trust to beat IHT
  • Consider writing any life policies into trust
  • Pensions: your secret weapon against IHT
  • Don’t forget to claim back any overpaid IHT
  • Keep on top of your planning
  • The inheritance tax is the most hated tax of all, because it hits grieving families when they are down, eating into the wealth loves ones have left behind. Effectively, families are being taxed twice on their wealth, as they may already have paid income tax, National Insurance and capital gains tax on the money during their lifetimes.

    Inheritance tax, or IHT, is also incredibly complex and despite promises, politicians have failed to simplify it. Worse, the £325,000 nil-rate IHT tax threshold has been frozen since 2009, dragging more and more ordinary families into the net every year as house prices and stock markets rise.

    If it had risen with inflation, it would stand at more than £500,000. This is a tax rise by another name. The only piece of positive news is that families will now benefit from another IHT exemption, known as the nil-rate main residence threshold.

    This allows them to pass on £175,000 of their main home’s value to direct descendants such as children and grandchildren. However, both IHT allowances have now been frozen until 2028, which means more ordinary families will fall into the tax trap.

    HM Revenue & Customs (HMRC) already pockets around £7billion a year from IHT tax and that looks set to rise. Don’t take this lying down. It is possible to reduce your own liability, allowing you to pass on more of your wealth to loved ones, and less to HMRC.

    It does take careful inheritance planning, though. Some measures are simple and you can do them yourself, others are more complicated and may require professional advice.

    Who pays inheritance tax?

    IHT was originally targeted at the super-wealthy but many now escape because they can afford to hire expensive financial advisers to discover tax loopholes and shrink their exposure.

    Increasingly, it is middle-income Britons who bear the burden. Yet many have themselves to blame as they fail to take simple steps that could save them thousands, in part because the rules are so complex.

    IHT is charged at a punitive 40 percent for all eligible assets, so the bill can quickly run into tens or even hundreds of thousands of pounds.

    Last year, 33,000 estates paid IHT, up by a third according to the OBR, with the average payment around £160,000. Some pay a lot more than that.

    In July 2019, the Office for Tax Simplification (OTS) suggested a number of rule changes to make IHT fairer and easier to understand. So far, little has been done.

    Millions of British taxpayers would like to see the hated “death tax” scrapped altogether. Sadly, that’s unlikely. Cutting the bill is down to you.

    Married couples are ahead in the inheritance game

    There is plenty you can do to reduce your own family’s IHT exposure, but don’t delay. The earlier you take action, the better.

    Being married has few tax advantages these days, but inheritance tax is one of them. That’s because married couples and civil partners are free to pass their possessions to their spouse or partner when they die, free of IHT.

    They can also pass on their unused tax-free £325,000 nil-rate band, and the additional £175,000 main residence nil-rate band. Together, these total £500,000.

    The surviving partner also has their own allowances. Combined, a married couple may be able to pass on up to £1million to direct descendants without paying a penny to HMRC. Not everyone will benefit, though. Six million couples now cohabit and cannot pass on these allowances.

    Any gifts to an unmarried partner may be liable for IHT. Many don’t realise how costly this can be until it is too late.

    Inheritance tax planning is not the most romantic reason to get married, but it could be one of the more practical ones.

    Beating inheritance tax is in your gift

    One of the best ways to reduce your exposure is by making gifts to loved ones, but you need to do this carefully. You can steadily whittle down the value of your estate by gifting cash, household and personal goods, such as furniture, jewellery or antiques, a house, land or buildings, and stocks and shares.

    However, you cannot simply give money away and expect it to fall outside your estate with immediate effect. HMRC will view any gift you make as a potentially exempt transfer, or PET. That means it will only become entirely free of inheritance tax if you survive for another seven years after making it.

    If you die in that time, the PET becomes a “chargeable consideration” and is added to the value of your estate when calculating IHT.

    Your tax exposure does reduce on a sliding scale, the longer you live after making the gift. This is known as taper relief.

    If you die between three and four years after making the gift, the IHT rate falls from 40 percent to 32 percent.

    If you die between years four and five, it drops to 24 percent, then to 16 percent between years five and six, and eight percent if you die between years six and seven.

    So it pays to start gifting while still in good health. If you leave it too late, you are more likely to pay IHT and at a higher rate.

    If you make a gift but still retain an interest in it, it will not qualify as a PET. For example, if you gift your home to a child but continue to live there rent-free, it will be considered part of your estate for IHT purposes. This applies even if you live there more than seven years.

    A word of warning

    Be warned, there is a danger that you could trigger a capital gains tax (CGT) bill when gifting certain assets. There is no CGT to pay on cash gifts, but there may be if you gift stocks and shares, or a property.

    In that case, you may have to pay CGT on any increase in value since you acquired them. For higher-rate taxpayers, this is charged 28 percent on gains from residential property, and 20 percent on other chargeable assets.

    Paying up to 28 percent CGT today to avoid a potential 40 percent IHT bill at some point in the future may not make sense. However, you can reduce the impact by using your annual CGT allowance, although this is less effective than it was.

    In the 2022/23 tax year, every UK adult was allowed to take profits of up to £12,300 before paying CGT on them.

    From April 6, 2023, Chancellor Jeremy Hunt slashed that back to just £6,000, and it will fall again to just £3,000 from 2024.

    Remember if the value of any assets you own has fallen, say, if a stock or investment fund crashes, you could offset your losses against any gains.

    Max out your annual IHT-free gift allowances

    Every year, you can gift £3,000 to anybody you like, with instant inheritance tax exemption. This allows you to make tax-efficient gifts to children and grandchildren, as well as other family members and friends.

    Every adult has their own £3,000 allowance, so couples could gift £6,000 in total. If you did not make use of last year’s gift allowance, you can mop this up by gifting another £3,000, as can your partner. In total, this means couples may be able to gift £12,000 in the current tax year.

    On top of that, you can also give unlimited gifts of up to £250 to any number of people, provided they haven’t benefited from the £3,000 exemption.

    Parents can also gift £5,000 to children on marriage, £2,500 to a grandchild or great-grandchild who is marrying, and £1,000 to another relative or friend who is getting wed.

    If you make gifts to help pay the living costs of an ex-spouse, an elderly dependent or a child under 18 or in full-time education, these might also be exempt.

    In a little-known exemption, gifts paid out of surplus income, which are not deemed to affect your standard of living, are IHT free.

    These could include regular payment’s into a children’s savings account, paying a life insurance premium for your spouse or civil partner, or even paying someone’s rent.

    Done properly, gifts will instantly fall out of your estate, plus you get to see loved ones enjoy them while you are still around. It is important to keep a clear record of what you have done, though, to avoid disputes with HMRC. Remember that once you give away money you have lost control and may struggle to get it back if you suddenly need it.

    Unfortunately, gifting allowances have failed to keep up with inflation, what have been frozen at these levels for years. As inflation rockets, value is being rapidly eroded in real terms. So don’t waste them.

    Consider setting up a trust to beat IHT

    Another option is to set up a trust or family investment company. This removes assets from your estate, so that they no longer belong to you, but you nonetheless retain a degree of control over them.

    By doing this, you are effectively freezing the value of the assets at today’s reduced prices. Any future growth is outside the estate.

    Gifts and money paid into trust are treated as potentially exempt transfers and will become IHT-free provided you live for another seven years after making them.

    Again, it pays to act while you are relatively young and in good health. There are many different types of trusts and this is a complex area, so you will almost certainly need specialist advice from a financial planner and a solicitor. Make sure they set out their charges in advance.

    There is one simple thing you can do yourself, though.

    Consider writing any life policies into trust

    Every year, thousands of estates pay IHT on the proceeds of a life insurance policy, when this could have been easily avoided.If you write a life policy into trust, it will not normally form part of your estate on death, but goes directly to your beneficiaries.

    It can also mean a speedier pay out in the event of a claim, as your family won’t need to wait for probate. Despite this, only six percent of life policies are written in trust, according to insurer Aegon.

    Insurance companies will typically send out a trust form when you take out a life insurance policy, which you can complete at no extra cost. Many people fail to fill it in, though. Their loved ones may regret that omission later.

    If you have life insurance and it isn’t in trust, phone your provider and ask for a trust form. This is particularly important if you take out a whole-of-life insurance policy. This type of life policy which remains in force until the policyholder’s death, provided they keep paying the regular premiums.

    Done properly, it can help prevent your home and other assets from having to be sold to pay an IHT bill. It must be written in trust, though.

    Whole-of-life insurance policies are usually sold by financial advisors, who will help with trust planning.

    Pensions: your secret weapon against IHT

    There are many benefits to saving into a pension – but a key advantage is that unused pension will fall outside of your estate for inheritance tax purposes, in contrast to other investments such as cash savings, Premium Bonds and Isas.

    So it may be worth using up other retirement savings and investments that are subject to IHT, such as Isas, before drawing money from your pension pots. That way you could pass more of your wealth to future generations.

    If you die before age 75, your pensions can be passed on entirely free of tax, although beneficiaries may pay income tax on the proceeds if you die later.

    The moment you take money out of your pension, it instantly becomes part of your estate and may be subject to IHT. This includes any tax-free cash.

    Don’t forget to claim back any overpaid IHT

    HMRC normally expects executors to calculate and pay all outstanding IHT within six months, which is typically before probate can be granted. This means in some cases, families do not know how much tax they owe, and risk overpaying.

    Another risk is that those assets fall in value before they are physically sold, and fetch less than expected. In that instance, overpayments can be reclaimed using form IHT35.

    Say an estate pays 40 percent IHT on investments of £100,000, handing £40,000 to HMRC. If those investments were eventually sold for £70,000, the executors could reclaim IHT paid on the £30,000 loss, giving them a £12,000 rebate. However, this only works if the person who sells the asset had also paid the IHT bill, typically the executor.

    If the asset has been distributed to a beneficiary who then sells, they cannot reclaim the IHT. If some of the investments increase in value, this will reduce the amount of IHT that can be reclaimed.

    A get-round would see executors only sell investments that have fallen in value, and assign those that have risen direct to beneficiaries.

    Some 10,000 families have reclaimed overpaid IHT in the last six years, but HMRC will not give the refund automatically. You need to claim it.

    Keep on top of your planning

    Inheritance tax planning isn’t something that can be looked at once and ticked off your to-do list. It needs to be reviewed regularly.

    Making a will is essential. This ensures your estate goes to who you want and that your wishes are carried out.

    Otherwise the law will decide how your estate is distributed and it is unlikely to be the most tax efficient way.

    This guide is only a run-through of the basics. Estate and tax planning is complex, so consider paying for professional advice to help you make the most of your allowances and avoid costly errors.

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