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Introduction:
Without proper guidance and financial support, Inheritance Tax (IHT) can cost families thousands of pounds. Although it is complicated to understand at first sight but there are various ways to avoid paying inheritance tax legally.
If you are worried about making the financial steps on your end, working with a financial adviser will ensure you make smart financial decisions and avoid paying the price in tax. Here we will talk about Inheritance tax and ways to reduce them while living in the UK. So, without any delay, lets get started with the details.
1. What is Inheritance Tax?
Inheritance Tax is a tax on the estate of someone who has died. This includes all property, possessions and money. Following death, the executors of the Will must calculate the value of all assets and deduct any liabilities (debts). The remainder is called your “estate”, and this is the value that’s liable to inheritance tax.
2. Which assets are within your estate?
Generally speaking, anything of value should be included in your estate for inheritance tax purposes. If the asset is jointly owned, then your share falls into your estate. This includes property, bank accounts, investments, shares, ISAs, antiques, jewellery, personal chattels, vehicles, life insurance (not held in trust) and gifts (made in the past 7 years). The asset value is determined to be the value at the date of death.
3. What assets are not in your estate?
Some assets fall outside of your estate and are therefore not subject to inheritance tax. This includes most types of pension plans, life insurance (held in trust) and trusts generally.
When someone dies, their outstanding liabilities will be repaid from their existing assets. This will reduce the value of their estate for inheritance tax. Funeral expenses are generally allowable deductions from a person’s estate for IHT purposes.
4. What is the 7-year rule in Inheritance Tax?
If you die within seven years of making a gift, some or all of the money you gifted will count towards your inheritance tax bill.
5. When does Inheritance tax have to be paid?
Your executors need to pay the inheritance tax liability within six months following death. If you do not, you risk facing a penalty.
6. Residential status and IHT
If you consider the UK to be your permanent home (i.e., you are UK Domiciled), IHT is payable on your worldwide assets.
If you don’t consider the UK to be your permanent home, inheritance tax is usually only paid on your UK assets only. It is likely that the country you live in will also have its own rules and regulations.
7. What is the UK Inheritance Tax rate?
Currently, you will pay an inheritance tax rate of 40% on your taxable estate. However, estate values can be reduced in many situations.
8. How to pay less or avoid Inheritance Tax
There are a number of legal strategies to avoid inheritance tax in the UK. Here we have 9 simple, time-tested ways to reduce your inheritance tax bill. You can use these methods yourself without wasting much on advisors.
8a. Make a will
Making a will is one of the simplest and easiest ways to make sure your money goes to the people you want. It allows you to choose how your assets will be managed on death, allowing you to plan for and minimise your inheritance tax bill.
If you do not make a will, the government will decide how your assets are distributed (under the rules of intestacy).
Control over your assets
Writing a will allows you to retain control over how your assets are dealt with to ensure your loved ones are provided for. A will is essential if you are not married or want to allow for assets to be passed on to step-children.
Tax-efficiency
Wills are a great way to put your tax affairs in order and legally shelter your assets from inheritance tax. For example, you can use your Will to make gifts that use up your inheritance tax allowance or to set up trusts.
You can also make sure that all the available inheritance tax exemptions are used at the right time. Ensuring you don’t pay more inheritance tax than you need to.
Setting up a Trust in your Will
When you set up a Will trust, you create a legal arrangement where you give cash, property or investments to someone else to look after them for a beneficiary. An example of this is if you choose to set up a trust fund for your grandchildren’s education costs. On your death, any assets that are held within a trust are likely to be exempt from inheritance tax.
There are also occasions where passing assets directly to the children can reduce the amount of inheritance tax paid.
Changing a Will after a death
You can make changes to a Will after somebody has died. This is known as effecting a deed of variation. This can help reduce inheritance tax, particularly where the intended beneficiary already has an inheritance tax liability.
For example, many grandparents leave their estate to their children. However, if their children are already financially sufficient and do not require the money, it will just sit in their estate untouched. On their death, inheritance tax may be paid on this money.
.8b. Make gifts
Gifting is an often overlooked but highly effective way of reducing the value of your estate for inheritance tax. There are no limits on the number of gifts you can make.
Giving away assets while you are alive still requires careful financial planning. You need to work out how much you can afford to give away whilst still ensuring that you have enough to meet your own needs.
Depending on how you structure the gift will determine how much inheritance tax is saved. There are two forms of gifting, known as “potentially exempt transfers” and “chargeable lifetime gifts”.
Potentially exempt transfers
A potentially exempt transfer is where you make an outright gift (i.e., you do not transfer money into a trust). You can make unlimited gifts in this way without any immediate inheritance tax charge.
If you survive for seven years from making the gift, it falls outside of your estate and there is no inheritance tax liability. If you die within seven years, then some or all of the gift will be included in your estate for inheritance tax.
Chargeable lifetime transfers
A gift that is not a potentially exempt transfer, is known as a chargeable lifetime transfer. These usually are gifts made to discretionary trusts and corporations.
You can make chargeable lifetime transfers of up to £325,000 every seven years without any immediate tax implications. Any amount in excess of this will attract an immediate inheritance tax charge of 20%.
If death occurs within seven years, then the cumulative value of the chargeable lifetime transfers will need to be calculated. Any amount in excess of £325,000 will attract a further inheritance tax charge of 20%.
Gifts out of income
If you receive more income than you spend, you can make a gift from your surplus income without any inheritance tax charge. The only limit is that the gift must come from income and not capital.
You should document your gifts carefully, and it should be clear that your lifestyle is being funded by your usual income. You cannot give away all your income and rely on your capital to fund your lifestyle instead.
Gifting, but not really
Many have tried to get around the inheritance tax gifting rules by ‘giving away’ assets. If a gift with reservation occurs, then the gift will still be treated as part of the estate of the deceased, even if they no longer own the asset on death. As such, inheritance tax will be paid.
The only solution to it is paying the market rent on the asset after making the gift. For example, you gift a property to your child at less than market value, but pay the market rate of rent to continue living there.
8c. Use your allowances
There are various different types of allowances, exemptions and reliefs which can reduce your inheritance tax liability. This includes the nil rate band, the residence nil rate band and annual gifting allowances.
What is the Inheritance Tax threshold?
You don’t pay inheritance tax on the first £325,000 of assets. This is known as your “nil rate band” or your “inheritance tax threshold. It is a tax-free allowance available for everyone.
If you die and leave your assets to your spouse, they will inherit your tax-free allowance. They will then have two tax-free allowances, allowing them to gift up to £650,000 before inheritance tax is due.
What is the residential nil rate band?
The residential nil rate band (RNRB) is an extension of the nil rate band. This provides you with an additional £175,000 tax-free allowance, however must be set against your main residence and be gifted to a direct descendent (child or grandchild).
As per the nil rate band, if you die and leave your main residence to your spouse, they will inherit your residence nil rate band. They will then have two allowances of £175,000, providing them with £350,000.
Combined, each person has an allowance of £500,000 that can be gifted without inheritance tax. Or, if you die and leave assets to your spouse, they will have an allowance of £1,000,000.
8d. Use your exemptions
Certain gifts are exempt from inheritance tax altogether. These include:
Gifts to spouses
Anything you give to your spouse during your lifetime or upon death (provided they live in the UK) is free of inheritance tax.
Annual exemption
You can legally give away £3,000 each tax year without attracting inheritance tax. If you have not used this allowance, you can carry it forward by one tax year, allowing you to gift up to £6,000. This allowance is per person, so if you are married, you can double this.
Wedding gifts
Giving cash gifts to newlyweds is a very common way to avoid inheritance tax. The level of tax relief varies depending on the relationship between the donor and those receiving the gift.
Parents and step-parents can give up to £5,000 tax-free. Grandparents can give up to £2,500, and other relatives and friends can give up to £1,000. These gifts have to be given on or shortly before the date of the wedding or civil ceremony.
Gifts to charities or political parties
There is no limit to the amount of money you can donate to charities or political parties. Gifts to charities in your Will also reduce the Inheritance Tax rate to 36%, provided that 10% of the “net estate” is passed to charity.
Small gifts
Gifts of up to £250 are defined as small gifts. You can make as many small gifts as you like without any inheritance tax implications. The only condition is that the gift cannot be part of a larger gift.
8e. Use business relief
Certain types of businesses and investments are eligible for “Business Relief”. This allows some or all of the assets to be passed on tax-free.
Business Relief
You can get Business Relief (previously known as Business Property Relief) on certain types of businesses and investments.
To qualify for Business Relief, the deceased must have owned the qualifying assets for at least 2 out of the last 5 years before death and at the date of death.
Investments and Business Relief
Certain investments exist which allow you to buy into a scheme that qualifies for Business Relief. This is useful when you want to retain control over the assets purchased (in case you need to sell at some point) but also aim to qualify for 100% relief against Inheritance Tax.
These schemes allow you to benefit from Inheritance Tax relief after two years, rather than to wait for 7 years if they make a gift. These investments are typically higher risk and you should seek independent financial advice before investing.
8f. Use life insurance
If you have a life insurance policy and die, your beneficiaries will receive a pay-out. If you haven’t placed the life in trust, then inheritance tax will be due.
Your life insurance policy needs to be written ‘in trust’ to separate it from your estate to avoid any inheritance tax. If done correctly, the net result is that your beneficiaries will receive your whole estate without a tax deduction.
You can either set up a ‘term’ assurance policy or a ‘whole of life’ policy. A term assurance policy will only cover you until a specific age. If you die within the term, it will pay out. A whole of life policy will pay out when you die, irrespective of when you die.
8g. Use trusts
A trust is effectively a separate legal entity. If you put assets into a trust, provided they meet specific requirements, they no longer belong to you. As a result, assets in trust are not included in your estate for inheritance tax. The seven-year rule however will still apply.
Using a trust provides a more sophisticated way to minimise your inheritance tax liability. Depending on the type of trust, it allows you to retain some control over how the money is used and who benefits.
8h. Invest tax-efficiently
With careful planning and tax-efficient investing, you can effectively avoid inheritance tax altogether. These investments tend to be more complex, that’s why working with an experienced financial advisor is essential.
Business Relief
Some types of investments buy shares in one or more privately-owned companies that qualify for business relief. If you hold these shares for two years, their value on your death will qualify for business relief, making them exempt from inheritance tax.
Examples of investments that qualify for business relief include:
· Enterprise Investment Schemes or Seed (SEIS / EIS)
Investments fall outside of inheritance tax after two years, there is an income tax relief of 50% for SEIS or 30% for EIS. Capital tax gain is deferred for 3 years allowing access to capital at any time. It’s a riskier type of investment as they tend to be in smaller companies.
· AIM Investments
Another method of obtaining Business Relief is through a portfolio of diversified holdings known as an AIM portfolio. This service provides investors with a portfolio of shares listed on the AIM index.
In addition to the IHT relief, an AIM portfolio provides the potential for capital growth and dividend income. However, if you receive any income or withdraw any capital growth then this will fall within your estate for inheritance tax.
Gift and Loan Trusts
A gift and loan trust plan are a flexible inheritance tax planning strategy. It provides you with a regular stream of income whilst gradually reducing the value of your estate. You can also withdraw your money at any time.
How does a gift and loan trust work?
You establish the trust and make a gift (loan) to the trust. The gift (loan) is repayable on-demand and attracts interest. The trust then uses this loan to purchase an investment bond.
This investment bond can be used to provide regular withdrawals to you, usually at 5% per year over 20 years (making up 100% of the original investment).
Benefits of a gift and loan trust
- Gradual inheritance tax savings on the investment growth
- You retain access to the capital and can withdraw this at any time
- You receive a regular income each year from the investment bond tax-free
- On your death, the capital can be inherited by your beneficiaries immediately without waiting for probate
Discounted Gift Trusts
A discounted gift trust provides you with an immediate inheritance tax saving. The inheritance tax saving will depend on your age/health and how much income you withdraw.
You will receive a regular tax-free income and retain control over who benefits from the capital. The main downside is that you do not have access to the capital yourself.
How do discounted gift schemes work?
You establish the trust and make a gift to the trust. The value of the gift is “discounted”. The discount amount will depend on your age, health and lifestyle. Any discount received will provide an immediate inheritance tax saving, even if you die within seven years.
If you survive the seven years, the total gift is outside of your estate for IHT. You are entitled to receive a regular, fixed withdrawal from the trust. Only when you die can the other beneficiaries receive the money in the trust.
Benefits of discounted gift schemes
- Immediate reduction in the value of your estate
- Full gift outside of your estate after 7 years
- Fixed, regular withdrawals for life
- Flexibility over beneficiaries
- Payment to beneficiaries without the need for probate on death
Types of trust
When establishing a trust, there are three main types of trusts. These are:
- Bare trust
- Discretionary trust
- Flexible trust
Bare trust
A bare trust allows you to specify who benefits from the trust. Otherwise known as an “absolute trust”, the beneficiary is absolutely entitled to the money. Once set up, the beneficiary cannot be changed.
They are typically used for minors, such as children under the age of 18. For example, a grandparent may decide that they want to help their grandchild with education costs.
Discretionary trust
A discretionary trust provides you with more control and flexibility over who receives the money and when they receive it. It provides you with the discretion to choose the trustees and the beneficiaries. You can change the trustees and the beneficiaries over time.
Flexible trust
A flexible trust or power of attorney trust specifies the principal trustee who will act on behalf of the settlor. The trustee is in charge of giving the assets to the beneficiaries. The trust also allows the trustee to use discretion when deciding who benefits from the capital.
Pensions
Pensions are one of the simplest and most effective ways to reduce your inheritance tax liability. This is because most pensions are treated as outside of your estate, meaning that they can be passed on tax-free. The inheritance tax benefits will depend on what type of pension you have.
Pension benefits
- When you die, you can nominate who you want to receive your pension. This does not have to be your spouse; you could choose for your pension to go to your children or anyone else for that matter.
- In most cases, the pension death benefits are free of inheritance tax, but this may not always be the case.
- With a defined benefit pension, the pension income will continue paying to your spouse or civil partner at a reduced rate (typically 50%).
- In addition to a regular income, some defined benefit pensions provide a one-off lump sum. Whether your beneficiaries pay tax on the lump sum will depend on how the pension has been set up.
Defined contribution pensions
With a defined contribution pension, there are up to three different options:
- Your pension can be paid out as a single lump sum
- Your pension can be paid as a secure income (also known as a pension annuity)
- Your pension can be inherited whilst remaining in the tax-efficient pension wrapper
Death before age 75
If you die before age 75, then the lump sum can be made to anyone completely tax-free, provided that the death benefits are paid within two years of the member’s death.
If you already have a pension annuity in payment, or your beneficiary selects a pension annuity, then any income will be taxable. This will be charged as income tax and the rate will depend on how much other income they already receive.
Death after age 75
If the pension scheme member dies after they reach age 75, then any pension death benefits are added to the recipient’s income for that tax year. The recipient will be liable to income tax between 0% and 45%, depending on the amount and their individual tax position. No inheritance tax is payable on this transaction.
Overall, beneficiary drawdown is the most tax-efficient way to inherit a pension. However, most pensions do not yet facilitate this new tax-efficient death benefit, as it is still relatively new.
8i. Spend more
One strategy to stop your estate from getting bigger and creating a larger inheritance tax bill is to spend more. Not only will this improve your lifestyle, this will also help you make sure that you pay less IHT as you stop your assets from growing.
However, finding the right balance between spending today and ensuring you are secure tomorrow requires a careful degree of planning.
Next steps
Inheritance Tax is a complex area of financial planning. By working with an independent financial adviser, you can reduce your inheritance tax bill, increasing the amount of money received by your beneficiaries.
To get started, we offer a complimentary inheritance tax consultation. This will help you understand how much inheritance tax you are likely to pay and what can be done to reduce it. If you want to reduce your inheritance tax bill, book in for your complimentary consultation today.
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