9 ways to reduce your inheritance tax bill
This article gives you everything you need to know and everything you need to do to reduce your inheritance tax bill.
In a nutshell, we’ll cover: Wills / Gifting / IHT Allowances / IHT Exemptions / Business Relief / Life Insurance / Trusts / Tax-efficient Investing / Spending.
Free inheritance tax consultation
Before we get started, please note that we offer a free inheritance tax consultation. This looks at your overall situation and provides some practical steps for how you can reduce your inheritance tax liability.
To claim your free consultation, all you need to do is find a date and time that works best for you. Once booked, you’ll receive an email confirming the meeting. It’s that simple!
An overview of inheritance tax
Inheritance tax (IHT) is paid when you die and sometimes when you give away certain assets during your lifetime.
If you are UK domiciled (i.e. you consider the UK to be your permanent home), it is payable on your worldwide assets. If you are domiciled outside of the UK, inheritance tax is usually paid only on your UK assets (as the country you live in will have its own rules).
Following death, the executors of your Will must calculate the value of your assets and deduct any liabilities (debts). The remainder is called your “estate”, and this is the value that’s liable to inheritance tax (IHT).
What is the UK inheritance tax rate?
Uk Inheritance tax is currently 40% of your taxable estate.
Estate values can be reduced in many situations, due to tax-free allowances such as the Nil Rate Band and the Residential Nil Rate Band (see below) as well as exemptions and reliefs.
You can reduce the 40% Inheritance Tax rate to 36% if you give at least 10% of your “net estate” to charity.
Some lifetime gifts are also chargeable at 20%, with a further 20% due on death if it occurs within 7 years of the gift.
Which assets are within your estate?
Generally, anything of value should be included in your estate for inheritance tax purposes. If the asset is jointly owned, then your share falls into your estate.
This includes property, bank accounts, investments, shares, ISAs, antiques, jewellery, personal chattels, vehicles, life insurance (not held in trust) and gits (made in the past 7 years).
The asset value is determined to be the value at the date of death.
What assets are not in your estate?
Some assets are deemed to fall outside of your estate & therefore not subject to inheritance tax. Examples include pension plans, life insurance (held in trust) and trusts generally.
Other allowable deductions
When someone dies, their outstanding liabilities should be repaid using their outstanding assets (where possible).
Costs incurred after death, such as legal expenses or probate fees related to the estate are not allowable deductions. However, funeral expenses are generally allowable deductions from a person’s estate for IHT purposes.
9 ways to reduce your inheritance tax bill
There are a number of legal strategies to avoid inheritance tax in the UK.
These are 7 tried-and-tested methods that can be used to avoid or reduce inheritance tax and are acceptable to HMRC.
1. Make a Will
Yes, it sounds simple, but making a Will is one of the best ways to deal with your IHT planning.
It allows you to choose how your assets will be treated on death, allowing you to plan and therefore minimise inheritance tax.
If you do not make a will, the state will decide how your assets are distributed (under the rules of intestacy). This is very unlikely to be the most tax-efficient method.
Control over your assets
When you make a will, you decide how your assets are distributed after you die. This allows you to retain control over how your assets are dealt with to ensure your loved ones are provided for.
The need for a Will is especially important if you are not married, or want to allow for assets to pass to step-children.
By making a Will, you can make specific gifts for certain people, and ensure that money goes to the right people.
A key benefit of making a Will is the ability to avoid inheritance tax. Wills are a great way to put your tax affairs in order to (legally) shelter assets from inheritance tax. For example, you can use your will to make gifts that use up your inheritance tax allowance or to set up trusts.
You can also make sure that all the available inheritance tax exemptions are used at the right time, for maximum efficiency.
Setting up a Trust in your Will
Your Will can create a trust that comes into force after your death. An example of this is if you choose to set up a fund for the benefit of a dependent, perhaps a child.
On your death, any assets that pass to your spouse are exempt from inheritance tax. However, assets that pass to children are not exempt and will use up some or all of your allowance.
There are occasions where passing assets directly to the children can reduce the amount of inheritance tax paid.
Changing a Will after a death – Deed of Variation
It is possible to change someone’s Will after their death. This is known as a Deed of Variation and can be used for IHT planning.
Imagine that you already have a large estate value and are the beneficiary of a Will. You do not need these funds, they will simply sit in your account until you die, at which point inheritance tax will be paid.
You might prefer for these funds to go directly to your children. Assuming they don’t exceed the available allowance, they can be passed directly to your children tax-free.
Any changes to the deceased’s Will must be agreed by all beneficiaries who may be worse off and must take place within 2 years of the death.
A Deed of Variation is a complex arrangement, so it’s wise to get legal advice to ensure this is done correctly.
2. Make gifts
You can make unlimited gifts during your lifetime. Gifting is an often overlooked but highly effective way of reducing the value of your estate for inheritance tax.
Giving away assets while you are still alive requires careful financial planning. You’ll need to work out how much you can afford to give away whilst still ensuring that you have enough to meet your own needs.
Potentially exempt transfers
Most lifetime gifts, excluding those made to certain trusts, are known as ‘Potentially Exempt Transfers. If you make a gift during your lifetime, there is usually no tax to pay at the date of the gift.
Potentially Exempt Transfers are useful tools for inheritance tax planning because they reduce the value of your estate, assuming you survive for seven years. If you die within seven years, then some or all of the gift will be included in your estate for inheritance tax.
Chargeable lifetime transfers
If a gift is not a potentially exempt transfer, it’s known as a chargeable lifetime transfer. These are normally gifts made to discretionary trusts and companies.
You can make chargeable lifetime transfers of up to £325,000 every seven years without any tax implications. Any amount in excess of this will attract an immediate inheritance tax charge of 20%.
If death occurs within seven years, then the cumulative value of the chargeable lifetime transfers will need to be calculated. Any amount in excess of £325,000 will attract a further inheritance tax charge of 20%.
Gifts out of income
Since you have already paid tax on your income, you can give away any excess without paying inheritance tax. This will need to be structured carefully to avoid IHT.
You should document your gifts carefully, and it should be clear that your lifestyle is being funded by your usual income. This means that you must be able to maintain your lifestyle from your income after making the gift, you cannot give away all your income and rely on your capital to fund your lifestyle instead.
Selling at below the market rate
You may be tempted to think that you can pass on assets for less than they are worth, and this might get around the rules on inheritance tax. Unfortunately, if you sell an asset for less than their true market value (e.g. selling a property at a discount to your child), then the discount will be treated as a gift & subject to IHT
Gifting, but not really
Many have tried to get around the inheritance tax gifting rules by ‘giving away’ assets but still continuing to enjoy the use of them (e.g. giving their home to a child, while continuing to live there). This is known as a ‘gift with reservation’.
If a gift with reservation occurs, then the gift will still be treated as part of the estate of the deceased, even if they no longer own the asset on death.
The only solution to the ‘gift with reservation’ of benefit rules is to pay the market rent on the asset after making the gift. It will then classify as a potentially exempt transfer.
3. Use your allowances
Everybody is entitled to a ‘Nil Rate Band’ of £325,000. This allows you to pass on assets up to £325,000 without inheritance tax being charged.
There is also the ‘Residence Nil Rate Band’ of £175,000. This allows you to pass on your family home up to £175,000 to direct descendants (such as children or grandchildren) before inheritance tax is charged.
Combined, each person has an allowance of £500,000 that can be used to reduce the value of their estate.
4. Use your exemptions
Certain gifts are exempt from inheritance tax. These include:
Gifts to spouses – Anything you give to your spouse during your lifetime or upon death is free of inheritance tax. Of course, when your spouse dies, depending on the value of their estate, inheritance tax may be payable.
Annual exemption – You can give away up to £3,000 in any one tax year without attracting inheritance tax. If you have not used this allowance in the previous tax year you can bring this forward for 1 year only (i.e. give £6,000 in year 1). This allowance is per person, so if you’re a married couple you can double this.
Wedding gifts – For weddings, you can give up to £5,000 for a child, £2,500 for a grandchild and £1,000 for a non-relative without attracting inheritance tax.
Gifts to charities or political parties – You may give as much money as you want to charities or political parties and effectively avoid inheritance tax. Gifts to charities in your Will also reduce the Inheritance Tax rate to 36% provided that 10% of the “net estate” is passed to charity.
Small gifts – Gifts of up to £250 are ‘small gifts’, where there is no inheritance tax to pay. You can give to as many people as you want in a tax year, without incurring any IHT.
5. Use business relief
Certain types of businesses and investments benefit from inheritance tax relief. This means that up to 100% of their value will not attract inheritance tax.
You can get Business Relief (previously known as Business Property Relief) on ownership of a business, or shares in a qualifying business.
To qualify for Business Relief, the deceased must have owned the qualifying assets for at least 2 out of the last 5 years prior to death, and at the date of death.
Business Relief can be claimed on:
- Business property and buildings – 50% relief available
- Unlisted shares – 100% relief available
- The above includes AIM-listed shares and Enterprise Investment Schemes (EIS)
- Shares controlling more than 50% of the voting rights in a listed company – 50% relief available
- Machinery – 50% relief available
Business Relief cannot be claimed on:
- Not-for-profit companies
- Companies that mainly deal with securities, stocks or shares, land or buildings, or in making or holding investments
- Companies that are being sold unless shares in the company buying the shares issue shares as payment
- Companies being wound up
Investments and Business Relief
Certain investments exist which aim to allow you to buy into a scheme that qualifies for Business Relief. This is useful where you want to retain control over the assets purchased (in case you need to sell at some point) but also aim to qualify for 100% relief against Inheritance Tax. These schemes allow you to benefit from Inheritance Tax relief after 2 years, rather than to wait for 7 years if they make a gift.
These investments are typically higher risk. You should speak with an independent financial adviser in the first instance.
6. Use life insurance
Life insurance is not a method to avoid inheritance tax, but rather a method to fund it when you die.
A whole-of-life insurance policy that pays out a tax-free lump sum on your death and can be used to pay any IHT liability upon death. If done correctly, the net result is that your beneficiaries will receive your whole estate without a tax deduction. Critically, the policy should be written in trust to ensure that the tax situation is not made worse.
Whole of Life cover is guaranteed to pay out the sum assured, provided you maintain the cost of the cover during the lifetime of the policy. Of course, the longer you live, the higher the cost.
The downside of using insurance is the cost – which can be expensive as you get older. The upside is that insurance provides a simple solution, whilst leaving you in full control of your assets.
7. Use trusts
Trusts are effectively a separate legal entity that can help you to avoid inheritance tax.
You can make gifts to trusts, which may allow you to exercise some control over the assets. You may also be able to place existing assets into trust to avoid inheritance tax (although such a transfer could attract income tax or capital gains tax).
Trusts are taxed heavily, so you should only make gifts to trusts after taking advice. Otherwise, you may find yourself avoiding inheritance tax only to end up paying an alternative tax.
With some careful planning and tax-efficient investing, you can effectively avoid inheritance tax altogether.
These investments tend to be more complex, but can be extremely tax-efficient.
Some types of investments buy shares in one or more privately-owned companies that qualify for business relief. If you hold these shares for two years, their value on your death will qualify for business relief, making them exempt from inheritance tax. Examples of investments that qualify for business relief include:
Enterprise Investment Schemes (EIS)
Enterprise Investment Schemes (EIS) qualify for 100% exemption from inheritance tax because they qualify for Business Relief.
Features of Enterprise Investment Schemes:
- Investment falls outside inheritance tax after 2 years
- Offset income tax at 30%
- Defer capital gains tax after 3 years
- Access to capital at any time
- Riskier investments as they tend to be in smaller companies
Another method of obtaining BR is through a portfolio of diversified holdings known as an AIM portfolio. This service provides investors with a portfolio of shares listed on the AIM index.
In addition to the IHT relief, an AIM portfolio provides the potential for capital growth as well as dividend income for the investors.
In order to qualify for BR, the portfolio must be held for two years and the underlying companies must be deemed to be eligible. It is also possible to transfer an ISA to an AIM ISA, to receive the above benefits, tax-free.
Advantages of Business Relief Investments
- Avoid inheritance tax after just 2 years
- You own & control the assets
- You can sell some or all of the shares at any stage if you need access to the money (this will lose Business Relief and reverse the Inheritance Tax savings)
- All potential investment growth is outside of your estate
Disadvantages of Business Relief Investments
- Business Relief investments can be expensive
- The underlying investments are risky
- Unquoted companies tend to be smaller, less well known & more difficult to value
- The shares may not be diversified, which poses additional risk
- Capital and income can fall in value
- Less liquidity – investments are not on a listed stock exchange, therefore slower to sell
- Business Relief could be withdrawn by HMRC at any point
Gift and Loan Trusts
A gift and loan trust plan is a flexible inheritance tax planning strategy.
How does a gift and loan trust work?
You set up a trust, which requires trustees and potential beneficiaries. You then make a loan to this trust, which is repayable on demand, with 0% interest. The trust uses this loan to purchase an investment bond.
This investment bond can be used to provide regular withdrawals to you, usually at 5% per year over 20 years (making up 100% of the original investment).
Once the debt is ‘repaid’ via the withdrawals, the income stops and the remaining investment growth is outside of your estate, ultimately passing to your beneficiaries.
Initially, there is no inheritance tax benefit. If you die the day after setting up the gift and loan trust, the loan would be paid back to your estate. But, as the loan is gradually repaid, the debt decreases & the investment growth remains outside of the estate. Importantly, you can demand repayment of the loan if you later need access to cash, retaining control.
Benefits of a gift and loan trust
- Gradual inheritance tax savings on the investment growth
- You retain access to the loan fund at any stage
- You get a gradual income from the investment bond
- The remaining benefits can be paid outside of your will on death rather than relying on probate
Discounted Gift Trusts
A discounted gift trust is a way for you to make an investment, which has an immediate inheritance tax saving but also permits withdrawals.
How do discounted gift schemes work?
You set up the plan by making a gift to a trust.
The value of the gift is “discounted”. The discount amount will depend on your age, health and lifestyle. Any discount received will provide an immediate inheritance tax saving, even if you die within seven years. If you survive the seven years, the full gift is outside of your estate for IHT.
You are entitled to receive a regular, fixed withdrawal from the trust. Only when you die can the other beneficiaries receive the money in the trust.
If you are older, or in poor health, you are likely to receive a larger discount, and therefore a greater initial inheritance tax saving.
Types of trust
You can use any of the following types of trust for discounted gift schemes:
- Bare trust – You specify the beneficiaries, which cannot be changed
- Discretionary trust – You specify a group of potential beneficiaries, but the trustees make the final decision from these people
- Flexible trust – You may specify the main beneficiary but the trust allows the trustees to also benefit a wider group of people
Benefits of discounted gift schemes
- Immediate reduction in the value of your estate
- Full gift outside of your estate after 7 years
- Fixed, regular withdrawals for life
- Flexibility over beneficiaries
- Payment to beneficiaries without the need for probate on death
Pensions can be an effective inheritance tax investment scheme as they can pass on lump sums outside of your will. The inheritance tax position for pensions depends on what type of pension it is.
Pension death benefits
When you die, your family will usually be entitled to receive the value of your pension scheme at death. The pension death benefits depend on the type of pension plan you hold. In most cases, the pension death benefits are free of inheritance tax, but this may not always be the case. This article is not a comprehensive guide but is instead intended to give you an overview of how most pensions are treated on death.
General position on pension death benefits
Usually, but not always, pension death benefits are paid via some sort of trust. This means that the payments pass outside of your will, and are usually free of inheritance tax. This depends on the rules of the pension scheme.
You can nominate anyone to receive your pension death benefits.
Death before age 75
If the pension scheme member dies before age 75, then lump sum or income payments can be made to anyone completely tax-free, provided that the death benefits are paid within 2 years of the member’s death.
Death after age 75
If the pension scheme member dies after they reach age 75, then any pension death benefits are added to the recipient’s income for that tax year. Therefore, the recipient will be liable to income tax between 0% and 45%, depending on the amount, and their individual tax position. However, no inheritance tax is payable on this transaction.
9. Spend more
One strategy to stop your estate getting bigger and creating a larger inheritance tax bill is to spend more. This will improve your lifestyle, and also help you to make sure that you pay less inheritance tax as you stop your assets from growing.
Understanding how much you can afford to spend without jeopardising your own lifestyle will be crucial.
Your overall goal should be to ensure that you reduce your inheritance tax liability but also ensure you never run out of money. Therefore, you should be careful not to deplete your assets too quickly.
Inheritance Tax is a hyper-complex area of financial planning. We urge those who are looking at their options to reduce IHT to seek independent financial advice, ideally from a Chartered or Certified adviser, to help navigate this minefield.
If you have some questions about IHT planning, feel free to give me a call on 01179 902 602.
All the best,
James Mackay, Independent Financial Adviser in Bristol