A ‘notoriously tricky tax’: How to minimise liability for IHT

When someone dies, the value of their estate becomes liable for inheritance tax. This is paid by the estate of someone who has died if its total value exceeds a set threshold called the nil rate band, which is £325,000 for an individual. 

Gifts made within seven years of a client’s death may also be added to the total value of the donor’s estate

This limit can be different, say, when a home is being passed to children or grandchildren, or where the threshold is combined with that of a spouse or civil partner.

As things stand, gifts made within seven years of a client’s death, and even some gifts, such as those made to trusts or companies, may also be added to the total value of the donor’s estate and, if the total value exceeds the threshold, potentially taxed at a reduced rate.

However, there are exemptions to this rule: gifts valued at less than £250 individually, totalling less than £3,000 a year or to help with certain people’s living costs are exempt from IHT.

Key points

• The nil rate band for inheritance tax for an individual is £325,000
• UK domiciled spouses and civil partners can transfer their whole estate to each other with no liability to inheritance tax
• Anyone who looks likely to be liable to pay the tax should start planning as early as possible

But now that pensions, in some form or another, can be passed onto the next generation, and the fact that house prices have skyrocketed over the past decade or so, IHT planning has become more crucial than ever. 

The level of IHT thresholds are such that it does not take much for many people to be caught by them. 

So what exactly are the liabilities and when should planning start?

Know the rules

It is important to remember that IHT is chargeable at a rate of 40 per cent of the excess of an individual’s estate over the nil-rate band, says Tracy Crookes, financial planner at Quilter Private Client Advisers.

She explains: “UK domiciled spouses and civil partners can transfer their whole estate to each other with no liability to inheritance tax but, on second death, a liability could arise depending on the value of the estate at that time. 

“However, where the surviving spouse/civil partner is non-UK domiciled, the transfer is not unlimited but restricted to £325,000 – or the IHT nil-rate band at the time if this changes.”

She adds: “As all individuals have a nil-rate band of £325,000, this means transfers to a non-UK domiciled spouse are [IHT] free where the estate is valued at £650,000 or less and any excess is chargeable at 40 per cent under the normal rules.”

According to Laura Suter, personal finance analyst at AJ Bell, IHT is a “notoriously tricky tax to navigate and understand”.

IHT increasingly falls on the middle class, with estates worth £10m or more paying an effective 10 per cent tax rate  Laura Suter, AJ Bell

For example, she points to recent research by HM Revenue & Customs, which found that just 45 per cent of people giving money actually knew how inheritance tax rules worked.

She says: “Despite the fact that each year only 25,000 estates actually pay the tax, IHT increasingly falls on the middle class, with estates worth £10m or more paying an effective 10 per cent tax rate, compared to a 20 per cent tax for those with smaller estates of £2m to £3m. 

“This is down to the fact that the wealthiest families get professional advice to make full use of the allowances, while those with smaller estates do not – highlighting the benefit of planning for [IHT].”

While clients are entitled to pass on assets of up to £325,000 free of tax, married couples and registered civil partners, can share their thresholds, transferring the unused element of their IHT allowance to the surviving spouse when they die, effectively doubling up the relief, notes Philip Whitcomb, partner and head of rural private clients at Moore Blatch.

He adds: “In addition, you have the residence nil-rate band which is rising in increments up to £175,000 in April 2020. 

“There are strict rules which you need to follow in order to claim the residence nil rate band, including leaving your property or an element of your property to your children or their descendants, and there are also tapering provisions if your estate is worth over £2m.”

Indeed, according to Ms Crookes, the new residence nil-rate band is “complicated and only available where an individual is leaving their home to their direct descendant(s) and tapers away where an estate value exceeds £2m”.

When to start planning

Anyone who looks likely to be liable to pay the tax should start planning as early as possible, according to Ms Suter.

She says: “The seven-year taper means that anyone who wants to gift money benefits from doing so sooner rather than later, and potentially avoiding paying IHT if they die within seven years of making the gift.

“That said, with the rising cost of care, people need to ensure that they aren’t giving away money that they may potentially need later in life.”

She adds: “While it is nice to be able to leave a nest egg for your children, family or friends, you do not want todo it at the expense of your own future.”

Many people leave planning for IHT too late, according to Mr Whitcomb.

He says: “The clear message is: the sooner you start the better. It is much more complicated and your options become limited the later you leave it.”

He continues: “A lot of people wait until death before passing on the wealth through their wills. However, it can be more tax-efficient to gift money and other assets while you are still alive. 

“At least that way you can see your loved ones benefit from the kind gift you have made them.”

Ms Crookes says: “Making a will is really important – it’s your way of saying who you would like to benefit from your estate and what you would like them to have.

“Without a will, rules known as the intestacy rules apply and your intended beneficiaries may have no entitlement.”

She continues: “It is easy to overlook IHT as an issue – it’s not a liability that you have to consider paying during your lifetime and, when you are gone, do you care if there is tax to pay and not quite so much left for your beneficiaries?

“When you’ve worked hard all your life to build up your estate, why would you want to give 40 per cent of it to the government in what is commonly considered a ‘voluntary tax’?”

She adds: “With careful planning, this can be avoided.”

Victoria Ticha is a features writer at Financial Adviser and FTAdviser.com