Inheritance Tax 

Reducing the impact of inheritance tax

This article is part of
In and outs of liability mitigation

Reducing the impact of inheritance tax

Inheritance tax is an easy trap to find yourself in – despite attractive new allowances that potentially offset the impact of house price inflation. 

We all have a nil rate band – in lay terms, an inheritance tax exemption – of £325,000. For couples, that is £650,000 (when one spouse dies their allowance passes to the remaining partner). 

Since April 5 2017 individuals have been able to claim an additional allowance of £100,000 to offset the sale of a family home on their death. The new tax allowance will rise to £175,000 by 2020 – meaning a couple can eventually expect to pass on £1m tax-free. 

Be aware though that this new residence nil-rate band is not designed to benefit wealthier individuals – the allowance is tapered on estates worth more than £2m – and the rules are complex. Generally speaking, to benefit, the deceased must have had a qualifying residential interest in the property – meaning it has been their home at some point – and the beneficiary must be 'closely inherited' – in other words, must be a direct descendant. 

As a result, there will still be many who need sensible estate planning advice. 

Planning process

The first task of any planner is to establish what the client has and where it is held, including pensions, which are now very IHT-efficient. If someone dies before the age of 75, any assets held within a pension wrapper can be passed to beneficiaries tax-free (subject to their lifetime allowance). After that beneficiaries pay tax at their marginal rate on drawing the assets, which might be less than the IHT rate. This makes pensions a key part of the estate planning strategy and means the adviser has an important role in helping clients decide what assets they draw on first in retirement.

If a client’s estate is likely to exceed the IHT threshold they have four options: spend, give money away, invest in IHT-qualifying assets or insure the liability. 

Gifting

The most obvious gifting strategy is through potentially exempt transfer (Pet). Clients can give their children or others as much as they like and it will be exempt from inheritance tax if they live for more than another seven years. If they die before that time, a taper potentially applies (see table).

Table

Years between transfer and death

 

Percentage of full IHT rate

Up to 3 years

100

3-4 years

80

4-5 years

60

5-6 years

40

6-7 years

20

This is the cleanest way to gift substantial sums but in our experience it can encourage many people to give away too much too soon, losing control of the assets. It is possible to use trusts allowing the donor to retain some control over gifts and access. Clients may also need to consider pre and post-nuptial agreements to protect family wealth passed down the generations from disappearing in divorce settlements. A good legal partner becomes a valuable asset in serving clients here.   

The key challenge with any gifting strategy is calculating how much capital is needed to cover potential liabilities. This is an issue not just of calculating longevity, but also of budgeting for end-of-life care costs. Commonly an adviser might allow four to five years at £40,000 a year per person. That would sap savings heavily for most clients and helps flag up the seriousness of giving too much capital away beforehand.