What is inheritance tax (IHT) and how can you legally avoid it?
Inheritance tax (IHT) is a tax on the value of assets that are passed on to another person when someone passes away. In England and Wales, the current IHT rate is 40% on the value of an estate that exceeds £325,000. The rules for IHT are quite complex and there are a number of different allowances which can help to reduce the IHT liability, depending on who are your beneficiaries and what is the composition of your estate.
If someone who is married or in a civil partnership leaves their estate to the surviving spouse or civil partner, the estate qualifies for 100% spouse exemption on anything they stand to inherit. If the £325,000 threshold has not been fully used when the first person in a marriage or civil partnership dies (i.e. If no significant gifts were left to other beneficiaries), the unused part can be transferred to the surviving spouse or civil partner.
This means that the basic tax-free allowance available when a spouse or civil partner passes away can be as much as £650,000 if none of their £325,000 threshold was used when the first partner of the couple passed away. The couple must be married or in a civil partnership when the first death occurred, and a request to HMRC to transfer the allowance must be sent within 2 years of the death of the surviving spouse or civil partner.
There is also an additional £175,000 tax-free allowance known as the ‘Residence Nil Rate Band’ (RNRB) which applies if you own your main residence, and leave this to a lineal descendant (i.e. either your children or grandchildren, but not a niece or nephew, unless you are their legal guardian). This can also be transferred to a surviving spouse. However, If the value of a person’s estate exceeds £2.35 million, there is no RNRB relief allowed and if the value exceeds £2 million, a taper is applied and the relief is reduced by £1 for every £2 that the value exceeds £2 million.
There are also a number of other rules which can be applied in certain circumstances. For example, Downsizing Relief is an exemption of up to £300,000 for the value of a home if it is sold and the proceeds are used to buy a smaller home, where the previous home would have caused the estate to qualify for RNRB, but the new home does not qualify. This serves to reverse any disincentive towards downsizing, assuming that people would otherwise concentrate their wealth in their home as a strategy to maximise RNRB relief and reduce the IHT bill when they pass away.
Gifts to loved ones made before death are taken into account when calculating the value of an estate for inheritance tax (IHT) purposes. The most commonly known rule is the ‘Seven Year’ rule, whereby after 7 years, any gift made during a person’s lifetime is no longer counted as part of their estate and is therefore not subject to IHT. However, the ‘Gift With Reservation of Benefit’ (GWR) rules also apply if a person retains any benefit from the gift after it has been made. For example, if a person gives their home to their child but continues to live in it rent-free, the gift will be subject to IHT.
Gifts to charities are exempt from Inheritance Tax (‘IHT’), whether they are made during a person’s lifetime or on death by their Will. In addition, you are encouraged to leave more to charity to benefit from a reduced rate of IHT. If when you pass away, 10% or more of the estate is donated to a registered charity, a reduced rate of 36% IHT will apply to the remaining chargeable assets rather than the full IHT rate of 40%.
A final method to minimise IHT is through the use of Trusts, which are a legal arrangement that can be used to hold assets and to distribute them according to your wishes after your death. Trusts can be away to reduce IHT, but they do not remove the liability completely and come with their own set of complex rules.
You may still need to pay 20% IHT when assets over a certain threshold are transferred into the trust, and a further 20% is payable if you pass away within 7 years of the transfer taking place. IHT is also charged up to a maximum of 6% on assets transferred out of a trust. Plus, IHT is charged at 6% on each 10 year anniversary of the trust, based on the net value of any relevant property in the trust on the day before that anniversary.
In summary, the simplest ways to reduce your IHT liability are to:
Maximise your IHT zero-rate allowances and Residence Nil Rate Band. This allows a couple who are married or in a civil partnership to leave up to £1 million in assets, without any IHT liability.
Transfer any gifts to your loved-ones as early as possible, but avoid retaining any benefit arising from these gifts.
Consider giving 10% of your estate to charity to reduce the rate of IHT on chargeable assets from 40% to 36%
Seek advice on using a Trust, if the above methods still leave you with a substantial IHT liability.
Ultimately, whether or not you should consider reducing your IHT liability is a personal decision. There are both moral and practical considerations to take into account.
