Avoid paying inheritance tax

Inheritance tax is likely to hit many more of us. Find out why and how you can avoid it.

Are you worried your family could be left with a huge inheritance tax (IHT) bill after you’re gone? IHT - or death tax as it is rather morbidly known - could be charged at a whopping rate of 40% on a chunk of the estate you leave behind.

Imagine giving such as huge sum of your money to the greedy taxman rather than your own carefully chosen benefactors? Doesn’t bear thinking about, does it? And, to make matters worse, many more of us are likely to be hit by IHT in the coming years. But fear not because they are plenty of ways you can reduce your liability, and preserve your wealth for your family.

Recent question on this topic

maxjaz asks:
a friend sold me one of his cars shortly before he died, for a nominal sum. Someone has reported this to HMRC as an attempt to avoid inheritance tax.
- manzanilla answered "a) is he over the inheritance tax threshhold? b) what was the car worth? c) in any case they..."
- maxjaz answered "As he had sold it to me, it wasn't considered to be part of his estate. It's worth maybe 200 times..."
- Read more answers

Why could more of you be hit with an IHT charge?

IHT only comes into play when your estate is worth more than a certain value. If it is valued below this amount - what’s known as the nil rate band - then there’s no IHT to pay. The nil rate band is normally up-rated every year. But in the last Budget, the threshold was frozen and will stay at the same level for the next four years.

This means many more estates will now become liable to IHT which would have escaped a charge if the nil rate band increased in the normal way each year.

How does IHT work?

In a nutshell, the nil rate band is currently set at £325,000. So estates valued up to this amount will be IHT free. Estates valued above £325,000 will be subject to an IHT bill of 40% of the excess. That means, if your estate was worth say £500,000, your family would be hit with a substantial £70,000 IHT bill.

But what counts as part of your estate? This includes the combined value of all the assets you own - such as your home, your possessions, cash and investments - from which any debts you still owe and funeral expenses are deducted. Your share of any jointly held assets are also included in the valuation calculation as well as the value of any assets held in trust.

You should also note here that some gifts you make during your lifetime may also form part of your estate. We’ll look at that in more detail in a moment.

How can you pay less IHT?

Nowadays, married couples and civil partners can effectively double the value of the IHT-free threshold to £650,000 when the second partner dies. This can be achieved by transferring any unused allowance on the death of the first spouse, or partner, to the second.

IHT may be charged at a rate high enough to make your eyes water, but there are certain gifts you can make during your lifetime, or as part of your will, which automatically escape it.

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Key IHT exemptions

First of all, gifts made to your spouse or civil partner are always IHT free, as are gifts made to UK charities, national institutions such as museums and universities, and UK political parties*.

What’s more, we all have an annual exemption of up to £3,000 which won’t be subject to IHT on death. If you don’t use your IHT free allowance in one year, you can carry it over to the next, and this amount can be given away in one go, or as a number of separate gifts. You are also entitled to a small gifts exemption of £250, which you can give to as many different individuals as you like without triggering IHT.

Meanwhile, any regular gifts made from your post-tax income, rather than capital, are also exempt as long as they allow you to maintain your normal lifestyle. This includes monthly payments to someone, or gifts for Christmas and birthdays.

Another exemption applies to wedding gifts. Parents can each give their children cash or gifts worth of £5,000 when they get married, or enter into a civil partnership. Grandparents can make gifts up to £2,500, while anyone else can gift a maximum of £1,000.

So you can see there are numerous ways you can keep IHT costs to a minimum. But there is another way you can put the brakes on your IHT bill.

What is a pre-inheritance?

Although ‘pre-inheritance’ is relatively new jargon, it refers to any gifts made to avoid or reduce IHT during your lifetime - rather than on death - beyond those we have already talked about.

According to insurance group Aviva, pre-inheritance is taking the place of traditional inheritance. In fact, an Aviva survey reveals almost of half (46%) of British adults have received gifts from a benefactor before their death.

The rules on pre-inheritance - or what is technically known as a potentially exempt transfer (PET) - are pretty simple: any gifts you make to anyone will be IHT free as long as you survive for seven years after making them. If you die before seven years has passed, the value of the gift will be added to your estate and used to calculate the IHT owed to the taxman.

If you pass away between three and seven years of making the gift, it’s value will reduce on a sliding scale for IHT purposes. (Check out this section from the HM Revenue & Customs website to find out more.)

The only proviso is that you must not retain an interest in the gift for the exemption to apply. For example, if you give away your home, but continue to live in it rent free, it won’t count as a PET.

What are the drawbacks of pre-inheritance?

If you’re concerned the value of your estate is getting close to exceeding the £325,000 nil rate band, a pre-inheritance could be an effective way of reducing IHT. But the biggest drawback is anticipating your future financial needs. You must be sure any pre-inheritance you give now won’t leave you short later on. Since IHT planning can very complex, it makes sense to consult a professional adviser first.

*providing the party has at least two members elected to the House of Commons, or has one elected member plus a minimum of 150,000 votes.