The amount of inheritance tax (IHT) paid by families has rocketed over the past decade, from £3.1bn in the 2012/13 tax year1 to £7.1bn in the 2022/23 tax year2.
This is partly because of rising property prices and frozen inheritance tax thresholds, but it is also a consequence of many families failing to plan early enough.
An additional inheritance tax allowance was introduced in 2017, but while this means some parents and grandparents can pass on more assets free of IHT, qualifying for the allowance isn’t straightforward.
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Read on to find out how inheritance tax works and some potential ways of mitigating it.
What is inheritance tax?
IHT is a tax on the transfer of wealth. Most commonly IHT is paid by the estate of someone who has died, but it can also be payable within someone’s lifetime. Your estate includes all your property, possessions, money, and other assets.
If your estate is valued at above the inheritance tax nil-rate band when you die, the excess will be liable for IHT. Currently, the standard inheritance tax rate is 40%.
IHT isn’t normally payable if you leave everything to your spouse or civil partner.
How does the IHT nil-rate band work?
The inheritance tax nil-rate band in the 2023/24 tax year is £325,000. It means that no IHT will be due on the first £325,000 of your estate when you die, regardless of who you leave it to.
Married couples and civil partners can transfer any unused element of their IHT nil-rate band to their living partner when they die. This means a couple has a joint nil-rate band of £650,000.
What is the additional IHT allowance?
In April 2017, an additional inheritance tax allowance was introduced called the ‘residence nil-rate band’. To qualify for this allowance, you must pass on your main residence, or the sale proceeds of your former residence, to your children (including adopted, foster or stepchildren) or grandchildren when you die.
For the 2023/24 tax year, the maximum residence nil-rate band is £175,000, meaning your overall IHT allowance could increase to £500,000. Like the standard nil-rate band, you can transfer any unused portion of your residence nil-rate band to your surviving spouse or civil partner when you die. Overall, a couple could potentially pass on up to £1m before inheritance tax becomes due.
The residence nil-rate band is tapered by £1 for every £2 that your estate exceeds £2m. This means that it won’t be available if your estate’s assets exceed £2.35m.
Remember, this additional allowance is only available if your home is left directly to your children or grandchildren.
How can inheritance tax be mitigated?
There are a range of reliefs and exemptions that, with careful planning, could be used to reduce an inheritance tax bill.
The first step is to ensure you have an up-to-date will. Some older wills hold assets in trust, which could mean you lose out on the nil-rate band or the residence nil-rate band. So it’s important to review any existing will you have.
Many people wait until death before passing on their wealth. However, it could prove more tax efficient to gift money while you are still alive. Tax-efficient gifts include:
- Gifts of up to a total of £3,000 each tax year – this is known as your ‘annual exemption’
- Gifts for weddings or civil partnerships: each tax year you can give up to £5,000 to a child, £2,500 to a grandchild or great-grandchild, or £1,000 to any other person
- Gifts from regular income
- Small gifts of up to £250 per person per tax year (so long as you haven’t used up another allowance on the same person)
Gifts not covered by an exemption are either ‘potentially exempt transfers’, meaning you must survive for at least seven years for them to be tax free, or ‘chargeable lifetime transfers’, which are immediately assessable to IHT and may result in IHT being payable.
Pensions could also be a tax-efficient way of passing on money to your loved ones. If you die before age 75, benefits left in a money purchase pension can usually be passed on tax free. After age 75, they will be taxed at the beneficiary’s marginal rate of income tax. It might make sense to use other investments, such as ISAs, to provide a retirement income and retain funds in your pension for as long as possible.
Other potential ways to reduce IHT include setting up trusts, specialist investment vehicles and whole-of-life insurance, but the best course of action is to seek professional advice early on. That way you’ll give yourself the best chance of passing on a legacy that suits your family’s unique circumstances.
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The value of investments, and any income from them, can fall and you may get back less than you invested. This does not constitute tax or legal advice. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness.
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