How to reduce or avoid inheritance tax
With rising property values, and changes to the rules concerning pensions, the number of people in the UK with estates exceeding the inheritance tax threshold will likely increase in the coming years. And, as a result, finding ways to reduce or avoid inheritance tax is becoming a crucial part of the wealth planning process.
Many question the fairness of this tax, given that it’s essentially levied on assets already subjected to a lifetime of taxation.
Whether you view it as a necessary part of fiscal policy or an unjust “death tax”, the reality remains that it can take a significant chunk out of your estate.
However, you’ll be pleased to know, there are a variety of ways to avoid inheritance tax or significantly reduce its impact.
What is inheritance tax?
Before delving into the ways to avoid inheritance tax, it’s essential to understand how it works. Essentially, it’s a tax is a on the estate (property, money, and possessions) of someone who’s died.
The current tax-free threshold, or “nil rate band”, is £325,000. Estates valued above this threshold may be taxed at 40%.
Given this potential financial impact, it’s no surprise many people and families seek out the best possible ways to mitigate inheritance tax.
Can it be avoided?
Yes, it is legal to avoid inheritance tax through legitimate means such as gifting, using trusts, and taking advantage of exemptions and reliefs.
However, there’s a difference between tax avoidance (legal) and tax evasion (illegal). It’s essential to follow the rules and seek professional advice to ensure compliance.
What are the different ways to avoid inheritance tax?
As detailed above, if your estate is large enough, your beneficiaries may be charged inheritance tax after you die.
If that is the case for your estate, you have two choices.
Acceptance or action.
If you’re keen to take action, here are 10 effective ways to help you plan for or avoid inheritance tax.
1: Gift your house to your children
Gifting your house to your children can be a strategy to avoid inheritance tax. However, this is fraught with problems, so it is important to seek professional advice to understand the implications.
At face value, this strategy seems simple – transfer your property’s ownership to your children. However, there are numerous underlying complexities. For instance, for the gift to be wholly exempt from inheritance tax, you need to outlive the transfer by seven years.
Moreover, if you continue residing in the property without paying rent, you might confront the “gift with reservation of benefit” rules which can bring its own set of challenges and tax implications.
Related reading: Can I gift my home to my children to avoid inheritance tax?
2: Make use of the spouse exemption
Leaving assets to your spouse or civil partner is another way to avoid inheritance tax. This exemption allows your surviving spouse to use their own inheritance tax allowance, effectively doubling the amount of your assets that can be passed on tax-free.
3: Benefit from the residence nil-rate band
The residence nil-rate band offers an additional inheritance tax allowance when you leave your home to direct descendants. This band, currently at £175,000 per person, could significantly increase the threshold and provide additional tax relief.
This was introduced to further alleviate the tax burden, especially concerning family homes.
When combined with the standard nil-rate band, a significant portion of an estate can be passed on free of tax.
4. Consider equity release to avoid inheritance tax
If you meet the qualifying criteria, equity release offers those who qualify the opportunity to unlock cash from your property.
Equity release has gained traction among the older generation, especially those who find themselves asset-rich but cash-poor. By opting for an equity release scheme, you can unlock a portion of your property’s value while continuing to reside in it.
There are two primary types: lifetime mortgages and home reversion. With a lifetime mortgage, you borrow money against your home’s value and it’s paid back, with interest, when the house is sold, typically after you pass away or move into care. In contrast, home reversion involves selling a part or all of your home in exchange for a tax-free lump sum or a regular income, while retaining the right to live in it.
Both options will effectively reduce the value of your estate, and consequently, the potential inheritance tax that might be due.
Sound interesting? Read our article on whether equity release be used to reduce your inheritance tax bill.
5: Use trusts to avoid or reduce IHT
Placing assets in a trust removes them from your taxable estate, allowing you to benefit from them during your lifetime and pass them on to future generations while reducing tax.
When it comes to trusts, there are a range of options to cater to various needs. From discretionary trusts, where the trustees have discretion over how to use the trust’s income, to interest in possession trusts, where beneficiaries have a right to the trust’s income but not necessarily its assets, the options are vast.
Trusts can not only shield assets from inheritance tax but can also provide ways to protect family wealth, control assets distribution, and support beneficiaries who might not be financially savvy. However, the rules surrounding trusts are complex and establishing one requires adherence to specific tax regulations and legal requirements.
If you need the advice of a specialist, find out more about our estate planning services today.
6: Explore life insurance options
Life insurance isn’t just about ensuring financial support for your dependents upon your demise. It can be strategically used as an inheritance tax planning tool. By setting up a whole-of-life insurance policy written in trust, its payout can be excluded from your estate’s value.
This means when the policy pays out, it could provide beneficiaries with a lump sum that could be used to settle the IHT bill, thus ensuring that core assets like family homes don’t need to be sold to pay the tax.
7: Make gifts out of income
Regularly gifting surplus income could reduce your inheritance tax bill. This approach could help to gradually reduce the size of an estate, and therefore used to avoid inheritance tax.
However, there’s a distinction between gifting from your capital and gifting out of surplus income. The latter, if done regularly as part of your normal expenditure without affecting your standard of living, is immediately exempt from inheritance tax.
This can include helping with a grandchild’s school fees or setting up a monthly financial gift to a family member. Documenting these gifts meticulously is vital to demonstrate their regularity and the source of income they come from.
8: Consider business property relief (BPR)
Investing in certain business assets, such as shares in unquoted companies and qualifying business property, could provide business property relief. This relief either exempts or reduces the taxable value of these assets, making it an attractive strategy for mitigating inheritance tax.
However, it’s crucial to understand which assets qualify. For instance, shares in a qualifying unquoted company might get 100% relief, while land, building, or machinery owned by the deceased but used in a business they were a partner in could get 50% relief. However, there are conditions to be met, like the minimum ownership period.
9: Explore relocation opportunities
Relocating to a country with more favourable tax rules, such as Portugal or Spain, could help reduce inheritance tax. However, careful consideration of costs and compliance with the regulations is essential when considering this strategy.
10: Use the annual gift exemption to reduce inheritance tax
Taking advantage of the annual gift exemption allows you to gift up to £3,000 each year without incurring inheritance tax. This cumulative allowance can be used to pass on substantial amounts over time, providing a tax-efficient way to benefit your loved ones.
Beyond the £3,000 limit, small gift exemptions also exist. For example, you can give away gifts worth up to £250 to as many people as you wish in a single tax year, provided you haven’t used another exemption on the same person. Over several years, these amounts can compound into significant transfers, all working towards reducing or avoiding inheritance tax.
Room for one more?
11. Consider charitable donations
Making charitable donations during your lifetime or including them in your will can reduce inheritance tax liability. Gifts to charity are exempt from tax, allowing individuals to reduce the taxable value of their estate while supporting causes they care about.
Looking for ways to avoid inheritance tax?
So there you have it – a whole host of effective ways to avoid inheritance tax in the UK.
Engaging the services of an inheritance tax planner is crucial for proper guidance tailored to your specific circumstances. A qualified professional would help review your estate planning arrangements, identify areas for improvement, and ensure compliance with the relevant laws and regulations.
Frequently asked questions (FAQs)
Need a recap? Looking to learn more about the different ways to avoid inheritance tax?
What are the best ways to avoid inheritance tax in the UK?
Reducing inheritance tax involves using trusts, making gifts at least seven years before death, and maximising allowances like the £3,000 annual gift exemption. Business Relief, and life insurance in trust can also help. A structured estate plan ensures assets pass on tax-efficiently while reducing or avoiding tax.
Can I avoid inheritance tax by gifting assets?
Gifting is one way to reduce inheritance tax, but timing matters. Gifts made more than seven years before death are usually tax-free. There are also annual allowances—£3,000 per year and small gifts of £250 per person. Larger gifts may still be taxed if the giver passes away within seven years.
Can pensions still be used to reduce inheritance tax?
As of the October 2024 Budget, pensions are now included in inheritance tax (IHT) calculations, removing their previous exemption. This means pension savings will now count toward an individual’s taxable estate, potentially increasing IHT liability.
What exemptions are available in the UK?
Several exemptions reduce inheritance tax. Gifts to spouses, civil partners, and charities are tax-free. The £3,000 annual exemption and regular gifts from surplus income also reduce tax exposure. Understanding and using these allowances can significantly lower the taxable value of an estate.
Do trusts help avoid inheritance tax?
Trusts can remove assets from an estate, reducing inheritance tax. However, certain trusts attract tax charges, and poor structuring can lead to unexpected liabilities. Bare trusts, discretionary trusts, and interest-in-possession trusts all have different tax treatments. Expert advice ensures trusts are set up correctly for tax efficiency.
Does inheritance tax apply to property?
Yes, property forms part of an estate’s taxable value. The residence nil-rate band (£175,000 per person) can reduce tax if the home is left to direct descendants. If the estate exceeds £2 million, this allowance is reduced. Downsizing or using trusts may help manage the tax burden.
What is the nil-rate band?
The nil-rate band is the amount of an estate that isn’t subject to inheritance tax. The current threshold is £325,000, with an additional £175,000 residence nil-rate band if passing property to direct descendants. Anything above this is taxed at 40%, though planning can reduce the liability.
How can married couples avoid inheritance tax?
Spouses and civil partners can pass assets to each other tax-free. They can also transfer unused nil-rate bands, doubling the tax-free allowance for their beneficiaries. Joint ownership structures and tax-efficient gifting strategies further help reduce the inheritance tax burden for future generations.
How can I plan my estate to reduce inheritance tax?
A structured estate plan includes gifting strategies, the use of trusts, pension planning, and life insurance in trust. Reviewing wills, setting up power of attorney, and ensuring assets are distributed tax-efficiently all help.
Can life insurance help avoid inheritance tax?
A life insurance payout is subject to inheritance tax if it’s part of the estate. Placing the policy in trust ensures beneficiaries receive the full amount tax-free. This can provide funds to cover inheritance tax bills without forcing the sale of family assets or property.
How does Business Relief reduce inheritance tax?
Business Relief allows certain business assets to be passed on free from inheritance tax. Shares in unlisted companies and businesses that qualify for relief may be exempt if held for at least two years. This is a key strategy for business owners looking to pass on wealth tax-efficiently.
