Inheritance tax, or the ‘death tax’, could be one of the most disliked taxes in the UK – no one wants their estate to be eroded away before it reaches their family. Currently, the tax-free threshold stands frozen at £325,000 for 2017-2021, or at £650,000 for couples. However, the steady rise in property prices over the past few decades means more and more people are exceeding this Nil-Rate Band, and liable to the 40% inheritance tax (henceforth IHT) rate – a hefty bill for many. However, there are many methods that can reduce this tax bill, which shall be outlined below.
Reducing your net estate liable to IHT can be achieved in several ways. In the UK, one can ‘gift’ away up to £3000 to a beneficiary without being subject to taxation, per year. This can be carried forward by one year as well, meaning that in any one year there is a total potential gift allowance of £6000. Gifting away your capital over time will reduce the tax bill to your family/children in the future. Moreover, up to £1000 can be gifted tax-free for a wedding, while £2500 & £5000 can be gifted for the weddings of grand-children and great-grandchildren respectively.
Any gifts that you make out of your after-tax disposable income can also be tax-free, however you need to be able to prove to HMRC that these gifts do not lower your standard of living. Thus, these should come out of any surplus or spare income. Money or assets of unlimited value can also be gifted to beneficiaries, known as a ‘potentially exempt transfer’ (PET), but the ‘7-year rule’ applies here. If you gift the income more than 7 years before you die, it is exempt from taxation, however if you die before these 7 years are up then the value of the gift is added to your taxable estate. This was famously illustrated when David Cameron’s mother gave a £200,000 gift in 2011, which is indeed tax-free if she does not die within 7 years of the transfer.
An attractive method for many is to gift away 10% of your net estate to charity. As well as this being tax free and philanthropic, the government will only charge 36% on your net estate (above the Nil-Band Rate) instead of 40%. This can prove to be both tax-effective and altruistic, allowing you to give to the charity of your choice after death.
Setting up a trust is another method to reduce the IHT bill. A trust is a legal arrangement whereby assets can be given to and controlled by a trustee, to the benefit of a beneficiary. Placing assets into a trust means they no longer belong to you – they belong to the trust. As a result it is given its own Nil Rate Band for inheritance tax. A discretionary trust is one of the most flexible of these vehicles, as it gives the trustees discretion as to the distribution of the funds. However, trusts are not exempt from tax altogether. IHT may be payable at 20% when you transfer any asset into it, if the total value of transfers into the trust over the past 7 years exceeds £325,000. Moreover, trustees must pay a charge every 10 years on the funds in the trust. This method for reducing inheritance tax is often complex and difficult to set up, so contacting a financial advisor is advised.
By using a pension plan, the IHT bill may be reduced in certain cases. In the UK currently, if you die before the age of 75 then you may pass any money in a pension plan to beneficiaries, tax-free. If you die after 75 however, the pension plan becomes a trust for the beneficiaries, who can then pay income tax on what they take out of the plan. The income tax paid on what is taken out of the plan can of course reach up to 45%, so a pension plan may not be a tax efficient scheme in this regard. On the other hand, while life insurance cannot reduce the tax bill, it can be used to substitute any estate tax bill after your death. This may ensure that your family is left with enough money to cover the bill.
Another route to consider is to invest in certain shares listed on the Alternative Investment Market (AIM). What some of these shares have in common is that they qualify for what is known as ‘Business Property Relief’ (BPR) – a form of tax relief that allows investors to avoid inheritance tax liability when they pass their holdings on to their heirs (so long as they have held onto their shares for at least 2 years). What’s better is that AIM-listed shares were allowed to be held in stocks and shares ISAs as of 2013, meaning up to £20,000 of your estate can earn tax-free income and growth, while being exempt from inheritance tax after death.
Gifting, trusts, AIM portfolio investing, and indeed all inheritance tax reducing schemes are complex to set up, and they are not guaranteed to reduce your tax bill if you set them up yourself. Proper financial consultancy is advised before any action is taken.