We work hard, pay tax on our income throughout life, and yet still face the prospect of paying 40% Inheritance tax when we die. Can this be right? Inheritance tax is regarded by many people as a voluntary tax, because with the right advice it can be legally avoided.
More people are being caught by Inheritance Tax
In the past, inheritance tax (IHT) was thought to be the curse of the wealthy. But nowadays the Nil Rate Band threshold of £325,000 is low enough that many people who wouldn’t class themselves as wealthy could end up paying IHT just because they own their home!
The steps to avoiding IHT
There are several key steps to avoiding inheritance tax: The most important of these is that you need to check if you have a liability as soon as possible, so you have plenty of time to do something about it
Another important step is to make sure you have an up to date Will. This can help to minimise the tax on your estate upon death, and in any case it’s a damn good idea! If you are legally married your allowances can effectively be combined, so if one of you dies the £325,000 allowance is passed on. When the survivor dies at a later there will be £650,000 available tax free (assuming the threshold stays unchanged)
If you can, start to pass on your assets to your children whilst you are still alive. Gifts of this type can be an effective way of avoiding inheritance tax and you have the added bonus of actually seeing your loved ones benefit from them. These Lifetime gifts are also known as potentially exempt transfers or PETs. They are potentially exempt, as you need to survive for seven years after making a gift to avoid inheritance tax completely. In some situations, the period may be longer than seven years.
This “7 year” rule doesn’t apply to any Gifts between husband and wife, as these are not liable to inheritance tax anyway, (even if you are legally separated). However, you must both be domiciled in the UK.
Other IHT Exempt lifetime gifts are as follows:
- Wedding gifts of up to £5,000 to each of your children, (this includes the person your child is marrying).
- Wedding gifts up to £2,500 to for a grandchild (including the person they are marrying).
- Wedding gifts of up to £1,000 to any other person.
- Small gifts of up to £250 can be given to any number of people, (but if you give a person more than £250 in a tax year, the whole amount is taxable unless it falls into one of the other exemptions)
- One single gift of £3,000 is also allowable. This particular allowance can be carried forward and used in the current tax year, (6 April- 5 April) if unused in the previous tax year any balance
- Gifts made from regular surplus income that has been taxed are also allowable. These will not be subject to IHT provided you have not used your capital to make the gift, and that you do not need to use your capital to top-up your income as a result of making the gift. For example paying £50 per month into a savings account for each grandchild is allowed. This is separate to the £250 gift allowance
- Payments for maintenance of a husband or wife or ex-husband or wife, your children who are under 18 or in full-time education and dependent relatives are usually free from inheritance tax.
- Payments to charities, housing associations, community amateur sports clubs, the National Trust and established political parties. This usually includes items donated to Museums etc. too.
Avoiding IHT on your house
Unfortunately, some people try to avoid IHT, and usually their schemes backfire. The most common of these relate to giving the family home to children, by transferring ownership at no cost. This invariably doesn’t work! If you continue to live in the property, you must then pay the market rent each month as a tenant with a proper tenancy agreement. If you do pay FULL rent then the 7 year rule applies to market value of the property. So if the house is worth £500,000, but you “sold” it to your son for a £100,000 the tax liability would still be based on the £500,000 value.
By FULL market rent I mean if the rent due on a similar property locally is £1,000 per month you must pay £1,000 or thereabouts. If you only pay £100 it would be clear that you are trying to avoid IHT. If you don’t actually pay the FULL rent this will be classed as a 'gift with reservation' and the gift is treated as if it had not taken place.
Using trusts
Ideally you should take advice on the use of placing assets into Trusts. These can be a very effective way of passing capital to your beneficiaries yet still keeping an element of control until you die. Gifts to trusts are also usually subject to the 7 year rule. The use of a trust can be as simple as completing a form provided by an insurance company to allow the proceeds of a life policy to be paid direct to the intended beneficiary. This can avoid the money being added to the estate and increasing the liability and has the added advantage that the person receiving the money does not need to wait for grant of probate, (the procedure for releasing money from an estate to beneficiaries).
Take out life insurance to pay the IHT bill
So you’ve made gifts etc. and still have a liability, what can you do? If you want your beneficiaries to receive the full value of your estate you may be able to take out Life insurance to protect the liability. This is usually in the form of a Whole of Life policy. If it’s in joint names it is written to pay upon the second death. Note this doesn’t actually reduce the tax bill, but instead provides your beneficiaries with the money to pay the tax. Sometimes insurance is not possible, due to ill health perhaps, and possibly waiting 7 years for a PET to become fully effective is also therefore not appropriate. There are other options that can reduce your inheritance tax liability immediately, or at least in the shorter term. These options are more complex and it is important to take qualified financial advice before considering them, as they may not be appropriate for you.
Darren Amos
Financial Planning Designer
If you would like to contact Darren for help with your financial affairs you can do so via the 'contact the adviser' button below.
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