Inheritance tax raised a record £5.4bn in the last few financial years – the highest amount since the current tax system was introduced 33 years ago.

Many people think 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, there are many exemptions that can help mitigate the tax paid but regrettably, many families fail to take full advantage of what is on offer, mainly because they don’t know they are liable, therefore 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 put off until the last minute, by which time it 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 you are domiciled 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 unused element of their IHT-free allowance to their living spouse when they die.

Doubling up the relief means a married couple or registered civil partnership have a joint nil-rate band of £650,000.

The new residence allowance

In April 2017 an extra allowance was introduced when a residence is passed to a ‘direct descendant’.

This is known as the residence nil-rate band (RNRB), and like the standard nil-rate band unused 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 then taxed at 40%.

The RNRB will rise in stepped up to £175,000 in April 2020, at which point couples with children will be able to leave up to £1m tax-free when they die.

The “voluntary tax”

On top of the nil-rate bands, there are a range of reliefs and exemptions that with careful planning can be used to reduce an IHT bill. 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.”

If you want to pass on as much of your wealth as possible, talking about inheritance is a vital first step.

Once you have started the discussion, creating an estate plan to suit your needs does not have to be difficult.

Making estate planning work for you

Step 1: First, think will

Before you move on to any other forms of estate planning it is essential that you 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 who you want and that your wishes are carried out.

Even if you already have a will you might need to take action. For example, you might need to revisit your will to benefit from the residence nil-rate band. The new relief will only be available if assets are left directly to descendants. As a lot of older wills hold assets in trust you could lose out if your will is not updated.

Many people set up mirror wills with their spouse, which means that 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 death 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 purposes to gift money while you are still alive.

Transferring wealth while you are alive can have a transformative effect on both your and your family’s life. Gifting money to a younger relative to top up their pension can substantially boost their income when they eventually retire.

  • Each year you can give away £3,000 and 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 give £2,500 and anyone else £1,000.
  • Keep a lump sum outside of your survivor’s estate to ensure it is not subject to IHT
  • Protect your children/grandchildren’s legacy if your surviving spouse remarries
  • Protect your children/grandchildren’s legacy from their own marital disputes
  • Avoid giving children/grandchildren a sum of money that 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 further 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 gifts are valued at more than the nil-rate band, taper relief will be applied. The tax reduces on a sliding scale if the gift was 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 for some, it makes more sense to be tenants in common. This means they each own a set share of the home. This can be half each, or a defined percentage. This enables each partner to pass on a share of their home on death to someone other than their spouse – their children, for instance.

This 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 the age of 75, benefits left in a money purchase pension can be paid as a lump sum or drawdown income to any beneficiary, with absolutely no tax to pay. After the age of 75 they will be taxed at the beneficiaries’ marginal income tax rate.

Most people overseas have “frozen” their national pensions, but it is worthwhile to review your beneficiaries and how they would receive the benefits.

It might make sense to use other investment structures whilst overseas such as QNUPS (Qualifying non-UK Pension Scheme,) HK ORSO (Occupational Retirement Scheme Ordinance.) These also have IHT free options depending upon your circumstances and where you want to live in the future.

Step 5: Take control with trusts

Trusts can reduce an IHT bill and give you control over how your assets are used by future generations.

Trusts can help you:

  • Keep a lump sum outside of your survivor’s estate to ensure it is not subject to IHT
  • Protect your children/grandchildren’s legacy if your surviving spouse remarries
  • Protect your children/grandchildren’s legacy from their own marital disputes
  • Avoid giving children/grandchildren a sum of money that they may not spend as wisely as you would like.

Trusts can be a complex matter but again, 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 a bigger 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 should be owned via 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 easy to rectify.

Step 7: Think about discounted gift trusts (DGT) if you are to return to the UK

An alternative option, if you can give up capital, is a discounted gift trust. These are designed 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 your 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 holding 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 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.

If you have a non-UK spouse or 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 UK, your EPT will be ignored and all relevant UK taxes will apply. You can change this to another though as most trusts are discretionary, therefore changeable.

Step 8: Further planning opportunities

Sometimes an estate plan is made up of a number of 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?