Inheritance Tax mitigation strategies
Inheritance Tax, or IHT, is one of the most significant financial challenges faced by families across the UK. Many are unaware that, without proactive planning, their loved ones could face a hefty tax bill on the assets they’ve worked tirelessly to build. With the right strategies, you can minimise or even eliminate a large part of this tax burden, ensuring that a legacy stays intact for future generations.
What is Inheritance Tax?
Let’s start with the basics—what exactly is Inheritance Tax?
In the UK, Inheritance Tax is a tax on the estate, that is the property, money, and possessions of someone who has passed away. The standard rate of IHT is 40%, but the good news is that it only applies to the portion of the estate that’s above the £325,000 threshold. This threshold is referred to as the nil-rate band.
For example, if your estate is worth £500,000, only £175,000 (£500,000 minus £325,000) would be subject to the 40% tax rate. But even then, there are ways to reduce this further.
One key element to consider is the residence nil-rate band. This allows for an additional £175,000 exemption if you’re leaving your home to a direct descendant—that’s a child, grandchild, or other close relative.
For married couples or civil partners, this combined allowance could reach £1 million, potentially eliminating any IHT liability if your estate falls within these limits.
Gifting as an Inheritance Tax Strategy
One of the most effective ways to reduce an Inheritance Tax liability is through gifting. By giving away assets during your lifetime, lowering the total value of an estate, ensuring more of it passes on to loved ones tax-free.
There are several types of gifts under the UK tax system that are either completely tax-free or partially exempt:
Annual Exemption: The Annual Gift Exemption allows you to gift up to £3,000 per tax year without it counting towards your estate’s value. If you didn’t use the previous year’s exemption, you can carry it over to the current year, allowing you to gift up to £6,000 in a single year.
Small Gifts: The small gifts exemption means you can give up to £250 per person, per tax year, to as many people as you like, with no tax implications.
Wedding Gifts: You can give tax-free wedding gifts of up to £5,000 to children, £2,500 to grandchildren, and £1,000 to other individuals.
Potentially Exempt Transfers, referred to as PETs are larger gifts that become exempt from IHT if you survive for seven years after making a gift. However, if you don’t survive the full seven years, a tapered tax rate applies based on how long it’s been since the gift was made.
But be mindful of the gifts with reservation of benefit rule. This applies if you give away an asset but continue to benefit from it, such as giving your home to your children while continuing to live there. In such cases, the asset will still be considered part of your estate for IHT purposes.
Trusts - A Powerful Tool For IHT Planning
Trusts are another excellent tool for inheritance tax planning. They allow a transfer assets out of an estate while retaining some control over how and when the assets are distributed. Let’s take a look at some commonly used trusts for IHT planning:
Discretionary Trusts: With discretionary trusts, the trustees decide how and when the beneficiaries receive the assets and allow trustees to change beneficiaries of the trust. The key advantage, as with other trusts, is that assets held in the trust are not part of an estate and are, therefore, not subject to IHT upon death.
Bare Trusts: A bare trust, also known as absolute trusts, gives the beneficiary an immediate right to the assets, meaning the assets will be taxed as part of their estate rather than yours. The downside is that the beneficiary may face capital gains tax (CGT) or income tax on the assets. Beneficiaries of Bare Trusts, unlike discretionary Trusts, are predetermined and can’t be changed.
Loan Trusts and Discounted Gift Trusts are specialized trusts that allow you to retain access to some of the income or capital while still reducing the inheritance tax burden on an estate.
While trusts can be powerful, they can also be complex and have tax implications, such as periodic charges every 10 years and exit charges when assets are removed from a discretionary trust. It’s crucial to seek professional advice to ensure your trust is set up correctly and tailored to your specific situation.
Life Insurance and Pension - Additional Ways to Mitigate IHT
Life insurance and pensions are two additional, extremely effective ways to protect an estate from inheritance tax:
Life Insurance: One popular strategy is taking out a life insurance policy specifically to cover a potential IHT liability. For example, if an estate is worth £1 million and you expect an inheritance tax bill of £270,000, a life insurance policy could provide the beneficiaries with the funds to cover that tax bill. The key here is to ensure the policy is written in trust, so it doesn’t form part of your estate and become subject to IHT itself.
Pensions: Pensions are an incredibly tax-efficient way to pass on wealth because the value of a pension doesn’t typically form part of an estate for IHT purposes. If you pass away before the age of 75, your beneficiaries can take your pension benefits tax-free. If you pass away after 75, they’ll pay income tax at their marginal rate, but still, no IHT will apply. By leaving wealth in a pension and drawing from other sources during retirement, you can maximize the tax-efficient transfer of wealth to heirs.
How John and Mary Reduced their Inheritance Tax Bill
Now, let’s look at a real-life case study to see how these strategies work in action.
Meet John and Mary, a married couple in their late 60s. Their combined estate, including their home, is valued at £1.2 million. Initially, they faced an IHT bill of £80,000 after fully utilizing their nil-rate band and the residence nil-rate band.
Here’s how they approached their inheritance tax planning:
Gifting: John and Mary started gifting £6,000 annually to their two children and four grandchildren. Over ten years, this reduced the value of their estate by £60,000, saving them £24,000 in inheritance tax.
Trusts: They placed £100,000 of their investments into a discretionary trust, removing this amount from their estate. This saved an additional £40,000 in inheritance tax.
Life Insurance: They also took out a £50,000 life insurance policy, written in trust, to cover any future IHT liability including future growth on their investments. This ensures no part of their estate would need to be sold to pay the tax.
Pensions: John and Mary left their pensions untouched, relying on their other investments for living expenses. This allowed them to pass on their pension funds IHT free to their children.
Through these combined strategies, John and Mary were able to reduce their IHT liability to zero, ensuring their estate was passed down to their family in full.
Final Thoughts
Inheritance tax planning is a critical step in protecting your wealth for future generations. Whether you’re gifting assets, setting up trusts, or using life insurance and pensions, there are multiple strategies that can help you minimise the IHT burden on your estate.
However, it’s important to remember that every situation is unique. What works for one family may not work for another. Seeking professional advice tailored to your specific circumstances is key to developing an effective inheritance tax plan.
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No financial decisions should be taken based on the content of this website or associated videos. The guidance contained within this website is subject to the UK regulatory regime and is therefore primarily aimed at viewers in the UK. Always take full individual advice first. Regulations and legislation governing taxation, investments and pensions may change in the future.
The content on this page is accurate as of the 2024-25 tax year.