Inheritance tax raised a record £5.4bn in the last few financial years – the highest amount introduced since the current tax system.
This article explains how to reduce an inheritance tax bill. It is deeply unfair that the estate they have worked so hard to build up can potentially be subject to a 40% tax charge.
Fortunately, many exemptions can help mitigate the tax paid. Still, regrettably, many families fail to take full advantage of what is on offer, mainly because they don’t know they are liable and don’t know what to do to mitigate.
Many find the idea of discussing inheritance uncomfortable. People wrongly assume that IHT planning must be complicated. Their reticence means that IHT planning is a priority at the last minute, which may be too late to make a difference.
Why you should consider IHT planning
Whenever someone dies, the value of their estate becomes liable for IHT IF they hold UK assets (property, stocks, gold), even if not from the UK. If your domicile is in the UK, your estate includes everything you own. Including your home and certain trusts in which you may have an interest.
However, everyone is entitled to pass on assets of up to £325,000 free of IHT.
This is called the nil-rate band. Married couples and registered civil partners can share their thresholds, transferring the new element of their IHT-free allowance to their living spouse when they die.
Doubling the relief means a married couple or registered civil partnership has a joint nil-rate band of £650,000.
The new residence allowance
An extra launch was introduced in April 2017 when a residence passes to a ‘direct descendant.’
This is known as the residence nil-rate band (RNRB), and like the standard nil-rate band, new elements of the allowance are transferable to a surviving spouse or registered civil partner.
In the 2018-19 tax year, the RNRB is £150,000 per person. This means a married couple with children can pass on a maximum of £850,000 in total without having to pay IHT – two lots of £325,000 (£650,000) and two lots of £100,000 (£200,000).
Any excess over this amount is a tax of 40%.
The RNRB will rise to £175,000 in April 2020, at which point couples with children can leave up to £1m tax-free when they die.
The “voluntary tax.”
On top of the nil-rate bands, a range of reliefs and exemptions are in use to reduce an IHT bill with careful planning. The former home secretary, Lord Jenkins of Hillhead, called IHT “a voluntary tax, paid by those who distrust their heirs more than they dislike the Inland Revenue.”
Talking about inheritance is vital to pass on as much of your wealth as possible.
Once you have started the discussion, creating an estate plan to suit your needs can be easy.
Making estate planning work for you
Step 1: First, think well
Before you move on to any other estate planning forms, you must have an up-to-date will. Making a will is one of the most important things you can do to ensure your estate goes to whom you want and that your wishes are received.
Even if you already have a will, you should take action. It would be best if you revisited your choice to benefit from the residence nil-rate band. The new relief will only be available if assets are left directly to descendants.
Many set up mirror wills with their spouse, meaning they leave their estate to the other in the event of their death. However, it might make more sense to make a will that transfers some assets to children or grandchildren after the end of the first spouse.
Step 2: Lifetime gifts – start with the simple things
Most people wait until death before passing on their wealth through their wills. However, it can be more tax-efficient for IHT to gift money while you are still alive.
Transferring wealth while you are alive can have a transformative effect on your and your family’s lives. Gifting money to a younger relative to top up their pension can substantially boost their income when they retire.
- Each year, you can give away £3,000; that gift will not be subject to IHT.
- You can also give £250 to any number of people each year.
- Parents can give £5,000 to each of their children as a wedding gift. Grandparents can provide £2,500 and anyone else £1,000.
- Keep a lump sum outside your survivor’s estate to ensure it is not subject to IHT.
- Shelter your children/grandchildren’s legacy if your surviving spouse remarries.
- Protect your children/grandchildren’s legacy from their marital disputes.
- Avoid giving children/grandchildren money they may not spend as wisely as you would like.
Gifts of any size to charities or political parties are also tax-free. If a gift is regular, comes out of your income, and does not affect your standard of living, any amount of money can be given away and ignored for IHT.
It is possible to make other tax-free gifts – potentially exempt transfers – but you have to survive for seven years after making the gift to get the full benefit of it being outside of your estate for IHT purposes.
If you pass away within seven years and the value of the gifts at more than the nil-rate band, taper relief will be applied. The tax would reduce on a sliding scale if the gift were made between three and seven years earlier.
Chart 1 – Taper relief rates.
Step 3: Consider how you own your home.
Typically, couples own their home as joint tenants. If one partner dies, the other automatically becomes the sole owner of the property.
This works for many couples, but it makes more sense to be tenants in common for some. Meaning they each own a set share of the home. It can be half each or a defined percentage, enabling each partner to pass on a share of their home on death to someone other than their spouse – their children, for instance.
It can help reduce an IHT bill and long-term care costs (UK.).
Step 4: Make use of pensions.
Pensions are one of the most tax-efficient ways to pass on your wealth. If you pass away before age 75, benefits left in a money purchase pension can pay in a lump sum or drawdown income to any beneficiary, with absolutely no tax to pay. After 75, the taxes are at the beneficiaries’ marginal income tax rate.
Most people overseas have “frozen” their national pensions, but reviewing your beneficiaries and how they would receive the benefits is worthwhile.
It might make sense to use other investment structures overseas, such as QNUPS (Qualifying non-UK Pension Scheme) and HK ORSO (Occupational Retirement Scheme Ordinance.) These also have IHT-free options depending on your circumstances and where you want to live.
Step 5: Take control with trusts
Trusts can reduce an IHT bill and give you control over how future generations use your assets.
These can help you:
- Keep a lump sum outside your survivor’s estate to ensure it is not subject to IHT.
- Shelter your children/grandchildren’s legacy if your surviving spouse remarries.
- Protect your children/grandchildren’s inheritance from their marital disputes.
- Avoid giving children/grandchildren money they may not spend as wisely as you would like.
Trusts can be complex, but once you have decided on what your estate plan should look like and taxes are taken into account (if any), the process does not have to be complex.
Step 6: Don’t forget life assurance
Personal life insurance (you are the policyholder and the life assured) creates an enormous IHT bill!
You are adding to the value of your estate when you die, adding to the tax liability.
Therefore, any life assurance you have is handled by a trustee or someone else (usually the spouse, as this provides insurable interest – you cannot just insure someone.) The policy owner then receives the proceeds of the sum assured – it does not go into your estate.
This is a common mistake that everyone makes but is easy to rectify.
Step 7: Think about discounted gift trusts (DGT) if you are to return to the UK.
A discounted gift trust is an alternative option if you can give up capital. These designs are for people who want to gift money to a trust, draw a regular income for the rest of their life and then pass what is remaining of the gift to their heirs free of IHT.
The trust purchases an investment bond (personal portfolio bond), which provides a tax-efficient income of up to 5% until death. If you survive for seven years, the (pp) bond does not count as part of your estate.
Even if you died within seven years, your heirs would receive a discount on the IHT because your right to draw an income from the gift reduces its value.
You could have still mitigated up to 2/3 of your IHT liability but hold the trust regardless of when you die.
Step 8: Think about excluded property trusts (EPT) if you are leaving your current country of domicile for another (not UK)
If you are not returning to the UK to reside but are likely to leave your current country of domicile, the minute you step out, you become UK Domicile again. This means that your global assets are valued when you die, and HMRC applies the levy to everything you own.
Whether you have a non-UK spouse or are likely to move to another country, an excluded property trust can be created to hold non-UK assets, and the contents would be IHT-free. Therefore, only UK properties would be liable for IHT.
At one point (until April 2017), a non-UK domiciled person could return to the UK with an EPT and NOT pay taxes on the contents … but no longer. If you are to return to the UK, your EPT is in disregard, and all relevant UK taxes will apply. You can change this to another, though, as most trusts are discretionary, therefore, changeable.
Step 9: Further planning opportunities
Sometimes an estate plan comprises several trust structures to maximise tax-free income and/or reduce or mitigate IHT.
Pensions, for example, are a trust in itself, so many people are drawing down tax-efficiently from these but also have other trusts in place to offer more income or capital (DGT or Loan Trust, for example.)
Holding UK assets requires you to double-check the complicated tax system the UK now enjoys. How do you remove unwanted taxes?
