What is inheritance tax?
Inheritance tax is a tax on your wealth that is paid on your death, however it can also apply to some gifts that are made during your lifetime.
Whilst inheritance tax (IHT) receipts had been steadily increasing year-on-year since 2009, 2019/20 saw the first drop in revenue in 10 years, with receipts down by 4% to 5.2bn. According to HMRC, this fall is due to the introduction of the Residence Nil Rate Band (RNRB) in 2017/18 which is now taking effect. The RNRB is discussed in further detail later in this article.
This total could still have been lower if more families had a plan in place. By not thinking about IHT planning, you are susceptible to a larger Inheritance tax bill, leaving less money behind for your loved ones.
Many people believe that inheritance tax only affects wealthy families, however, rising property prices have meant more of us are paying inheritance tax.
In the words of Benjamin Franklin, - “in this world nothing can be said to be certain, except death and taxes”.
Whilst inheritance tax is a tax on your wealth that is paid on your death (IHT can also apply to some gifts that are made before someone dies), it doesn’t have to be inevitable. Inheritance tax advice can help to reduce your tax liability and a TPO adviser will be able to help you explore your options.
What is the inheritance tax limit?
Everyone has a £325,000 inheritance tax nil-rate band. If you are married or in a civil partnership, you have a combined nil-rate band of £650,000.
From April 2017, an additional main residence nil-rate band was introduced. For the 2022/23 tax year, the individual allowance remains at £175,000. To qualify the individual’s main residence must be passed down to a direct lineal descendant.
If a person’s estate value exceeds £2 million, the residence nil-rate band is reduced by £1 for every £2 over £2 million. Anyone with an estate valued in excess of £2.35 million will not be able to benefit from this additional main residence allowance.
What is a direct descendant?
A child (including a step-child, adopted or foster child) of the deceased and their lineal descendants (their children’s children and grandchildren) and the spouses/civil partners of direct descendants (including their widow, widower or surviving civil partner).
Is your estate susceptible to IHT?
If your individual estate is valued at £950,000, assuming one nil rate band and no residence nil rate bands are available, an individual benefactor would pay an inheritance tax bill of £250,000 in 2022/23.
£950,000 – the nil-rate band (£325,000) = £625,000.
£625,000 x 40% = £250,000.
The tax must normally be paid within six months of the end of the month in which the benefactor has died (There are some exceptions such as property, land etc).
If your individual estate is valued at £950,000 and you are leaving your family home (valued at £175,000 or more) to a direct descendant, a benefactor with one nil rate band and one residence nil rate band available would pay an inheritance tax bill of £180,000 in 2022/23.
£950,000 – the nil rate band (£325,000) - the residence nil rate band (£175,000) = £450,000.
£450,000 x 40% = £180,000
To help you visualise these numbers, we've put together this Inheritance Tax calculator:
How to reduce your inheritance tax bill?
In order to ensure as much of your wealth is passed on as possible, it’s important to think about IHT planning. Spending, making personal gifts during your lifetime and understanding the allowances can all help, however if your estate is complicated, you may benefit from engaging a financial adviser.
Research indicates that over 30% of people only start to consider IHT planning after they reach the age of 55.
Regardless of where you live, your estate may be liable to UK IHT on your UK assets and may even extend to assets you own overseas.
Many people delay Inheritance tax advice conversations until it is too late to make a difference. However, we have set out some options that may, potentially, be available to you in mitigating this liability.
Our structured approach to planning considers the following:
Tips & questions to help you start planning
In terms of your inheritance tax liability, simply spending more is a very effective way of freezing/reducing the value of your taxable estate - but remember to leave yourself with sufficient capital for your own needs!
Make personal gifts
We have already mentioned some of the exempt gifts you can make during your lifetime such as the annual gifting exemption or regular gifts from surplus income.
Gifts made to relatives or friends during your lifetime which are not exempt gifts may be exempt from or eligible for a reduction in inheritance tax, however, you must live for 7 years after making the gift for it to be completely outside of your estate.
These gifts are sometimes known as Potentially Exempt Transfers, or PETs.
If you are not sure whether you need to consider inheritance tax planning or would like to know more about these simple strategies download our Inheritance tax factsheet.
More complex planning solutions
Another method of addressing potential inheritance tax liabilities is to make a gift into Trust. This type of planning can take place during your lifetime or on your death.
If you make an outright gift, such as a PET, you give up ownership and lose control over it which can be daunting. Instead, some people turn to trusts.
Whilst you are still giving away the asset you can, in most cases, maintain control over how the trust asset is managed and who can benefit from the Trust as a Trustee.
It is important to note that you cannot benefit from the Trust personally if it is to be effective for inheritance tax.
Best of both worlds?
There are particular types of Trusts which you can establish where you will retain the right to either capital or income during your lifetime but which are still effective in reducing potential inheritance tax liabilities. We have provided a brief overview below:
How does a Discounted Gift Trust work?
A Discounted Gift Trust (DGT) involves gifting away a lump sum of capital into an appropriate trust and then receiving a fixed regular income stream for your lifetime (provided sufficient funds are available). Dependent on your age, gender, health and value of the income stream chosen, a portion of the capital gifted is deemed to be immediately outside of your estate for inheritance tax purposes.
This can be a useful arrangement if you wish to try and obtain an immediate reduction in your potential inheritance tax liability and receive an income.
What is a loan trust?
This is a loan into the trust which remains in an individual’s estate and is repayable on demand, which means full access to the capital is retained.
Any growth on the investments held in the trust falls immediately outside of the estate for inheritance tax purposes. This type of planning is often favoured by individuals who cannot afford to gift away a capital sum but want to limit any future growth in the value of their estate.
Loan Trusts are effective for mitigating a potential inheritance tax liability, as any growth on the investments held in the trust immediately fall outside of your estate for inheritance tax purposes.
Using life insurance in preparation for an inheritance tax bill
There are two types of policies that may be applicable: whole-of-life assurance and term insurance. Assurance is intended to cover you until you die, whereas insurance covers you for a set period of time.
It is important to note that these policies are not intended to reduce the possible inheritance tax liability, but instead to pay the inheritance tax liability.
Whole of Life Policy
This type of policy allows you to specify an amount to be paid out on your death tax free as a lump sum. Your beneficiaries could use this to pay any inheritance tax due to HMRC.
This type of policy will pay a lump sum on your death if it occurs during a specified time frame. You can choose between a “level-term” or “decreasing term” policy.
It is particularly useful where you have made large gifts in recent years and you are worried that you may not live for seven years before the gifts fall outside of your estate.
Most life insurance policies used to cover an inheritance tax liability will be placed within a trust in order to avoid the policy proceeds forming part of the estate on death and also to enable the funds to be accessed before probate is granted in order to settle the inheritance tax bill.
There are other strategies and reliefs available which can be used to mitigate an inheritance tax liability on your estate but these generally require you to own a specific type of asset and/or have a higher risk approach to investment as well as capacity for losses.
Examples include investing in assets which qualify for:
- Business Relief
- Agricultural Relief
- Woodland Relief
- Gifting in Lieu
The Financial Conduct Authority does not regulate Estate Planning, Will Writing, Tax Advice or Trusts.
If you would like to know more about how we can help you with IHT planning speak to an adviser for more information.