Cut your tax bill with this Xmas gift

Give this gift to your loved ones at Christmas and you'll cut your tax bill by thousands of pounds!

In a recent lovemoney.com survey, we found that inheritance tax was one of Britain's most hated taxes, second only to the dreaded council tax. In fact, 45% of you want inheritance tax - or IHT - scrapped altogether.

But no such luck. I don't think IHT will be abolished anytime soon. In the meantime, why not take every precaution to cut your IHT bill as much as you can? Christmas is, strangely enough, the perfect time to do it!

Inheritance tax - the basics

IHT is a tax levied on the value of an individual's estate on death and is charged at a whopping rate of 40%. This tax year - which ends on 5 April 2010 - IHT applies where an estate is worth more than the current IHT threshold of £325,000, or £650,000 for couples.

The threshold normally rises each year, but the Chancellor announced in the pre-Budget report that it would be frozen in the 2010/2011 tax year. This has only made IHT even more unpopular with the British public.

Why should I care?

At one time IHT was seen as a tax on the wealthy alone. Only a small minority had estates worth in excess of the threshold. But rampant house price growth has changed all that, pushing many more people up into the danger zone where their estates are now valued above £325,000.

Don't forget, any amount over £325,000 is subject to a 40% tax charge. This is a huge part of your wealth to lose to the taxman, rather than passing it onto your family. But, thankfully, there are plenty of ways you can avoid a painful IHT bill - or at least reduce it. I'm going to look at one in depth which is particularly good to know at Christmas.

Cash gifts

IHT not only applies to the value of your estate on death, but also to cash gifts given during your lifetime. The rules work in this way to prevent people from giving away large amounts of money to slash the value of their estate below the threshold, and therefore escape IHT.  

If you survive for seven years after making a gift it will become what's known as a 'potentially exempt transfer'. Potentially exempt transfers - or PETs - are no longer be subject to IHT.

But certain gifts are IHT-free anyway. For example, you can make gifts to your spouse or civil partner, UK charities, any UK political party* and national institutions such as museums, universities and the National Trust, all of which are exempt from IHT whether the gift is made during your lifetime or as part of your Will. However, gifts made to an unmarried partner that you're not in a civil partnership with won't be exempt.

Annual exemptions

On top of that, you can give away cash gifts worth up to £3,000 in each tax year which are free of IHT when you die. Any unused allowance from one year can be carried forward to the next, giving a maximum allowance of £6,000. But the allowance can only be carried over once.

Additionally, you can make small gifts worth up £250 to as many people as you like in any one tax year. But remember you can't use the small gifts allowance alongside any other exemption when you give cash to the same person.

All this means you can give money away as a gift this Christmas specifically to avoid incurring a hefty tax penalty later on.

Regular cash gifts

Better still, you can also make regular cash gifts which won't take an IHT hit. To qualify, the gifts must be paid from your after-tax income and not taken from any source of capital, such as your savings. The gifts must also not affect your ability to maintain your standard of living. In other words, you'll need to be able to afford to make the regular gifts from your normal income, without reducing your assets.

You can make gifts monthly if you wish, or on regular occasions such as Christmas and birthdays. This would be a great way of building up a savings nest egg for a relative without the taxman taking a bite.

Alternatively, you can now pay into a pension on someone else's behalf. Everyone - including children and people without earnings - are entitled to open a Stakeholder pension and contribute up to £3,600 gross - or £2,880 net - every tax year.

Sim if you're a parent or grandparent, for example, you could make a regular gift into your child's or grandchild's pension up to a maximum of £2,880 per tax year. They will then get a £720 top-up from the Government - even if they're not a taxpayer!

This will help them plan for retirement while sneakily getting a bit of tax back from the taxman.

True, a pension or savings account may not seem like the most festive of gifts, but it's certainly something they'll thank you for later on. And it's a lot more sensible than giving a Go Go Hamster.

If you're looking for tips on how to minimise tax, why not try asking other lovemoney.com readers for help at Q&A?

*To qualify for IHT exemption, the gift must be made to a UK political party which has at least two members elected to the House of Commons, or has one elected member but the party received at least 150,000 votes

More: How to cut your inheritance tax bill | Look forward to painful tax increases