Inheritance tax is in the headlines once more with possible changes in discussion. We summarise the situation, so you can fully understand the implications that may or may not happen!
Let’s cast our minds back to Jeremy Hunt’s Autumn budget (November 2022) and you may remember the proposed removal of the Lifetime Allowance on pensions was amongst other announcements. The Chancellor also opted to freeze the IHT (Inheritance Tax) threshold for a further two years until 2027/2028. As the nil rate band of £325,000 and the residential nil-rate band of £175,000 have not been increasing with inflation and are not due to do so, more families and more assets are encountering an IHT liability due to rising property prices and asset values.
Have you considered what the value of your estate is?
Some have forecast that the frozen IHT threshold could net the government more than £1 billion! The average inheritance tax bill could reach £304,567 by 2025/26 and £345,084 by 2027/281.
What is Inheritance Tax?
Inheritance tax is a tax that is levied on the estate of a deceased person before the assets are passed on to their beneficiaries. The tax is typically calculated based on the total value of the deceased person’s estate, including their property, money, possessions, and investments, minus any debts.
How much is Inheritance Tax?
The standard Inheritance Tax rate is 40% on the value of an estate above a certain threshold (known as the nil-rate band). However, various exemptions, reliefs, and allowances can reduce the amount of IHT payable:
- £325,000 of assets (Your Nil Rate Band)
- An additional £175,000 residential exemption (Your Residential Nil Rate Band) is available in certain circumstances. See below.
- There is an unlimited exemption between spouses and civil partners,
- Gifts to registered charities or a community amateur sports club2.
Here’s an example
Your estate is made up of capital and investments (and no main residence) and is worth £500,000 with a tax-free threshold of £325,000. The Inheritance Tax charged will be 40% of £175,000 (£500,000 minus £325,000). The amount of tax due is £70,000.
However, many of us hold a sizeable portion of our estate in our home’s worth. So, how is that taken into account?
Residence Nil Rate band
The main residence nil-rate band was introduced to provide an additional tax allowance to individuals who pass on their primary residence to their direct descendants to reduce the potential IHT liability for family homes. If someone dies and their estate is worth more than the basic Inheritance Tax threshold their estate may qualify for the residence nil rate band of £175,000 before any Inheritance Tax is due.
Here’s another example
An estate left to children includes:
- a home worth £300,000
- other assets worth £190,000
The maximum available residence nil rate band is £175,000. The basic Inheritance Tax threshold is £325,000.
Estate value = £490,000
£490,000 – £175,000 = £315,000.
Less basic Inheritance Tax threshold = Tax is due on £0.
The associated rules and thresholds can change, so it’s essential to seek advice on the eligibility for the Residence Nil Rate band, as not every estate qualifies. Several mandatory conditions apply, including the net estate value should be below £2 million.
Steps you can take to reduce your IHT
You can implement a plan to reduce the Inheritance Tax burden on your estate and enhance the inheritance you leave to your beneficiaries by leveraging tax allowances, exemptions, and specific investment instruments. Various strategies can help, but we encourage you to seek professional guidance as they can be complex.
Here are four different choices available:
1. Gifting
There are several gifts to individuals that are exempt from IHT including:
Annual Exemption –you can make annual gifts of capital up to £3,000. If this allowance remains unused during a tax year, you can carry it forward to the next year, but it will be forfeited thereafter, if not used.
Small Gifts – gifts of up to £250 to any person within a single tax year are exempt from Inheritance Tax. This exemption cannot be combined with the annual £3,000 exemption, meaning you cannot gift a total of £3,250 using both allowances. However, the £250 gift allowance is unlimited on the number of people.
Normal Expenditure – Gifts are considered exempt from Inheritance Tax if they meet the criteria. Specifically, they must be proven to be:
- part of your regular spending pattern.
- come from your income, rather than your capital or savings and these gifts mustn’t impact your ability to maintain your usual standard of living.
There is no specific limit on the amount that can be given away in this manner. However, it’s essential to avoid compensating for the money given away by using your capital to cover your expenses. In other words, you should be able to demonstrate that the gifts are genuinely funded from your regular income and do not deplete your capital. This is an important consideration to ensure that the gifts remain exempt from Inheritance Tax.
Gifts on Marriage/Civil Partnership – exempt gifts include £5,000 given to a child, £2,500 given to a grandchild or great-grandchild or £1,000 given to anyone else.
There are several other types of gifts which are exempt, but those listed are the most commonly used 3.
Gifts that exceed the specified allowances are classified as Potentially Exempt Transfers (PETs). At the time of making such a gift, there is no immediate IHT payable. However, there can be potential consequences for your IHT liability for seven years following the gift. After seven years, no IHT will be payable on the gift at all.
2. A Trust
A trust is a legal arrangement where you can transfer cash, property, or investments, effectively removing them from your estate and placing them under the care of a trustee for the benefit of one or more beneficiaries. While trusts can offer various benefits, such as reducing the amount of Inheritance Tax paid on your estate, there are important considerations to keep in mind:
- Restricted Access to Capital: When you place assets in a trust, you typically give up direct control and access to those assets. The trustee manages them on behalf of the beneficiaries according to the terms of the trust.
- IHT Implications: If you pass away within seven years of a transfer into a trust, your estate may still be subject to Inheritance Tax. This is known as the “seven-year rule,” which means that gifts into certain types of trusts may not receive immediate IHT exemption.
Trusts can be a complex area of estate planning, and the specific type of trust as well as its terms and tax implications, can vary. Seeking professional advice on estate planning and taxation is highly recommended to ensure you set up the right trust for your needs and comply with all relevant regulations.
3. Life Insurance
You could also consider taking out a ‘Whole of Life’ insurance policy to address the IHT liability on your estate. A ‘Whole of Life’ policy, with a sum assured to match the expected tax liability would be placed in trust for the beneficiaries. Upon death, the insurance policy would pay out, providing funds to pay the IHT bill, thereby they will receive more of the estate value.
AIM Investing with Business Property Relief
Created in 1995, AIM is the London Stock Exchange’s international market for smaller growing companies. Unlike the main stock markets, some AIM companies qualify for Business Property Relief, and it is through this mechanism that brokers can run specialist AIM portfolios set up to mitigate Inheritance Tax.
Business Relief is a tax relief provided by the UK government, as an incentive for investing in specific types of trading companies. Investments into AIM stocks qualify for Business Property Relief (BPR) after being held for a qualifying period of two years. If the AIM investment is held for more than two years and still held at the date of death, the plan value falls outside your estate for inheritance tax purposes, thereby reducing your IHT liability.
Investing in the AIM market comes with risk, so it is important to obtain advice to ensure you fully understand the risks involved.
So, what have we learnt?
There is never a ‘one size fits all’ answer with inheritance tax, and any further changes to this area of financial planning will mean even the most organised amongst us will need to review their arrangements.
Estate planning and Will writing is an important aspect of your financial planning. We would always request you seek appropriate guidance to ensure your wishes are correctly reflected in any document.
Tax is dependent on your circumstances and personal situation and is subject to changes based on UK legislation and taxation regime. This article is based on our understanding of current legislation.
If you are keen to begin taking steps to reduce the IHT liability on your estate, please contact one of our advisers to assist you in implementing a strategy based on your own circumstances.
Limits and rates are correct as of October 2023.
Topics covered are for informative purposes and should not be considered as personal advice.
Have you considered inheritance tax in your estate planning? Let us know by adding a comment below.
1 IHT receipts hit £5.3bn as experts heed record-breaking year
Guest Author: Kirsty Davis, Business Analyst, Legal and Medical