Inheritance Tax Planning

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Inheritance Tax Planning

Inheritance tax planning with Tracey O’Reilly-Johnston.

What is inheritance tax?

Inheritance tax has been in the spotlight over recent years. Previously it was seen as a tax on the rich, but with house prices steadily increasing over the years and the nil rate band remaining at £325,000 since 2010, more and more people are now finding that it could become an issue for them. 

Personally, I look at it as a nice problem to have. Inheritance tax, or IHT as it’s more commonly referred to, is essentially a death tax. It’s a tax that’s applied on the assets you pass to your loved ones when you die. 

It will include any property, savings and possessions – we usually refer to this as your estate. It can also be applied to some gifts that you make in your lifetime as well. 

The current standard rate of inheritance tax is 40% – a whopping amount of tax. That amount will be payable to HMRC and it’s calculated after any debts, liabilities or funeral expenses have been deducted. 

Why is it important to understand inheritance tax?

Inheritance tax can cost loved ones hundreds of thousands when you die, depending on the size of your estate. In fact, more than £7 billion in inheritance tax was handed over to HMRC during the last year. 

IHT can be controversial. The argument against it is that you have paid tax when the money’s earned, so to have to pay tax on it again really isn’t fair. The other side is that inheritance tax redistributes income. So some of the money goes back to the state and is distributed for the benefit of us all.

But inheritance tax is a financial fact – so it makes sense to see if it’s going to affect you and what you can do to soften the blow. The rules around IHT can be quite hard to understand at first. It is important to get your head around it – you’ve worked really hard to build your wealth and you want to make sure that it continues to be preserved as far as possible. Without the right arrangements in place, IHT could affect how much you can leave behind.

What are your inheritance tax allowances?

When you pass away, if you’ve left all of your estate to your spouse or your civil partner, there will be no liability to inheritance tax at that point. It won’t become payable until the second person in the married couple or civil partnership passes away. 

There are allowances that can help you reduce your liability to inheritance tax. Each individual will have a Nil Rate Band. This is effectively the first £325,000 of your estate. That means that no inheritance tax will be due on the £325,000 when you die, regardless of who you leave it to. 

Married couples and civil partners can transfer any unused part of their Nil Rate Band to their living partner when they die. That means that a couple will have a joint Nil Rate Band of £650,000 – quite a high amount.

A new separate allowance was introduced in 2017 – the Residence Nil Rate Band. In order to qualify, you need to leave your main residence or the sale proceeds from it to your children. That can include adopted, fostered or stepchildren. 

You could also leave it to your grandchildren when you die – it’s your direct descendants, really. You can’t leave it to a niece or a nephew – it must be a child or a grandchild. For the current tax year (April 2023 to April 2024), the maximum Residence Nil Rate Band is £175,000. Overall, then, your inheritance tax allowance could increase to £500,000. 

As with the standard Nil Rate Band, you can transfer any unused portion of your Residence Nil Rate Band to your surviving spouse or partner when you pass away. Overall, a couple could potentially pass on up to £1 million before any inheritance tax becomes due. 

What do we need to understand about the Residence Nil Rate Band?

There is one other rule to remember – the Residence Nil Rate Band is only available up to the market value of your main residence. If your house is valued at £300,000, this will be the maximum you’ll be able to claim against the value of your estate. 

If you were to downsize – which a lot of people do – and you’ve done that after 6 April 2015, if your current property is worth less than your previous residence, you can use the equivalent to the sale price of your former residence. You’re not going to lose out there. 

For individuals whose estate exceeds already £2 million, the Residence Nil Rate band is tapered away at the rate of £1 for every £2 over £2 million. So it won’t be available if your estate exceeds £2.35 million.

How do you reduce your liability to inheritance tax?

The good news here is there are a range of reliefs and exemptions, so with careful planning they can be used to reduce any potential inheritance tax bill. 

The first step would be 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 with your solicitor. 

I can’t reiterate enough how important it is to have a will in place. Alongside careful expert inheritance tax planning, that will ensure you pass on more of your wealth to the people and causes that you choose. 

One of the easiest ways to mitigate inheritance tax is just spend your money or make the most of your gift allowances. You could also think about giving away some of your estate while you’re still alive.

How do gifts reduce inheritance tax?

Some gifts are not included in your estate for tax purposes – gifts to your spouse or civil partner, for example. You can make gifts to each other throughout your lifetime as long as you’re both domiciled in the UK. 

You can also make gifts to other people of up to £3,000 in total each year, under your annual exemption. You are also allowed to to carry this forward for a maximum of one year, so you could gift up to £6,000 in a particular tax year. 

You can make any number of small gifts up to £250 each year to separate individuals. These gifts are meant to cover things like birthdays and Christmas presents, but you’re not allowed to combine them with annual exemption gifts. You can’t gift the same person £3,000 and then another £250. You can also make gifts to UK registered charities.

You can give £5,000 if your son or daughter get married – if you’re a couple that could be £10,000. If your grandchild or another relative is getting married you can give them £2,500. As a guest attending a wedding if you have some spare cash and an IHT exposure, you could give the happy couple £1,000 – I’m sure they’d be very grateful! Being generous can also help reduce your IHT liability.

There is another way you can gift which people don’t often know about. This one’s really useful with inheritance tax planning. You’re allowed to give away money from excess income that’s not required for your day-to-day living. This exemption allows you to give away money after you’ve covered all your necessary expenditure. This gift should not reduce your standard of living, not come from any of your capital and be a pattern of regular spending. 

You can distribute any unspent income that would otherwise accumulate and end up within your estate. A lot of our clients use this to reduce future IHT liability. They make regular gifts to help to pay for grandchildren’s school fees or education. You’ll just need a record – which can be as simple as a letter to your child telling them of your intention to make the gift on a continuing basis.

You should also keep a record of your ongoing income and expenditure to demonstrate that the gift is being made out of surplus income. 

What other ways can I manage the IHT liability?

Another very straightforward way to cover liability to inheritance tax is to insure yourself against it. It’s particularly useful for certain assets such as property, as they are difficult to give away or put into trust. 

Using excess income you could buy a whole of life insurance policy that will pay out a lump sum on your death. That’s then used to pay some or all of your estate’s inheritance tax bill. It’s usually written into trust, so the proceeds won’t form part of your estate. The funds will be paid to the trust beneficiaries before probate is granted. 

Making regular gifts out of the excess income can be very useful in preventing further increases in your estate’s taxable value. You could use regular gifts to fund pension contributions, to build up an ISA or even just send the family on a regular holiday every year.

It’s essential, though, that you keep good records. It’s key to making a successful claim for gifts from surplus expenditure. 

You can also gift some of your assets – your cash, your art or your property. This can be an efficient way to reduce the value of future taxable estate. If you do decide to do this it’s crucial that you no longer benefit from the assets. 

If you give somebody a very expensive painting but you continue to keep it hanging above your fireplace, that won’t work. That’s actually known as a gift with reservation. 

With any gift you must survive for seven years after making the gift. These gifts are known as potentially exempt transfers. If you die within seven years the recipient of the gifts may have to pay IHT on the value of the gift. But there are some tax reliefs that can apply from year three of making the gift.

Are there any other ways to reduce an inheritance tax liability?

For some clients, putting things into a trust may be a suitable option. When you put money or assets into your trust you give up the right to them – they have left your estate. The value may not be counted for IHT purposes. 

Again, that seven year rule applies. If you survive for seven years after they’ve transferred into the trusts, they’re going to be outside of your estate and IHT. 

Some gifts into trusts can be chargeable lifetime transfers. You need to bear that in mind when setting up a discretionary trust. There’s a 20% inheritance tax charge when the value of the asset placed into the trust exceeds the nil rate threshold. 

So if you are thinking about creating a trust, speak to a financial advisor. We will help you avoid these unnecessary tax charges. Say you’re transferring assets worth £400,000 and the Nil Rate Band allowance is £325,000. There’s going to be an inheritance tax at 20% on the £75,000 difference – that’s a tax bill of £15,000. 

An advisor will help you avoid that trap. Trusts are really complex and everyone’s circumstances are different – plus there are various types of trusts out there. An advisor will help you select the most appropriate option for you. 

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Whenever you choose to seek an advisor we will help you get into a better financial position than you are today.

How does business relief work?

For some clients there are specialist investments that can reduce your liability to inheritance tax. They relate to a range of assets that qualify for tax relief called business relief. Once qualifying assets are held for two years, they achieve exemption from IHT providing that you still hold them at the time of your death. 

This approach will carry a higher investment risk compared to the other options and so it’s not suitable for the majority of people. When using these specialist investments, you don’t give away any of your assets – you still have ongoing access to your capital. You don’t have to survive the seven years – it’s just two years with this type of investment. 

You need to make sure that any arrangements you select are not going to leave you struggling to maintain your own lifestyle. Don’t give everything away – you need to keep something for yourself.

Does a deed of variation prevent inheritance tax?

A deed of variation allows the beneficiaries of an estate to alter how it is distributed by changing the deceased’s will. The effect is that the original beneficiary can redirect the legacy to someone else, without it being counted as a gift from the original recipient. 

An example might be an older beneficiary that varies the will in favour of their grandchild, as they don’t really need the money. The advantage is it’s not going to form part of the intended recipient’s estate or be taxed again when they eventually die. 

Of course, it’s preferable to set up your will and your estate to consider the implications before you die and make sure your wishes can be respected as far as possible. Again, this is where advice on inheritance tax planning can really help you.

Should I get married to reduce my liability to inheritance tax?

The romantic in me would never condone this action. But those of us in marriages and civil partnerships do actually have the benefit of the joint Nil Rate Band – both the standard Nil Rate Band and the Residence Nil Rate Band. 

That’s an exclusive IHT benefit to those in marriages. But I’m not sure if I would want somebody to marry me as a way to save on tax.

Can executors donate to charity to reduce any potential inheritance tax?

This is probably one of the nicer ways to reduce your inheritance tax liability. Any gift that you make to a UK charity is exempt.

In fact, if you leave more than 10% of your net estate to charities – it doesn’t have to be just one – the rate of inheritance tax reduces from the standard rate of 40% to 36%. That’s going to greatly reduce your IHT bill, plus your chosen charity benefits greatly from the cash injection. 

Can I use my personal pension to reduce inheritance tax?

Definitely. Using your personal pension and making full use of your annual pension allowance is a great way to mitigate your IHT liability. That contribution will be outside of your estate immediately. 

In fact, the recent abolishment of the lifetime allowance in the Spring 2023 budget means that pension savers can potentially pass on unlimited sums to the next generation free of inheritance tax. So using a pension pot to reduce IHT is a very popular tax planning strategy.

It allows people to pass all their wealth to their loved ones. Pension pots are not included in the value of the owner’s estate for inheritance tax purposes. If they’ve passed away before the age of 75, beneficiaries can withdraw the full amount of the pension tax-free. 

That may not be the best thing to do – it depends on your circumstances. You could leave it in the pension arrangement to eventually become your pension. It still remains outside of your own estate for inheritance tax purposes. 

There are some practical things to do if you want to pass on your pension to your loved ones. The first is that you should only really withdraw the money that you need from your pension. Your retirement savings are only considered outside of your estate for IHT purposes if they remain in your pension. 

So if you want to leave your pension to your loved ones, you should manage your withdrawals. Leaving the remainder where it is means that your pension savings continue to be invested in a very tax efficient environment.  Potentially there’s further growth for the remainder of your retirement. 

If you’re leaving your pension to loved ones, how much tax they’ll be liable for could depend on their income from other sources and how they plan to use the money. So it’s worth having a conversation with the potential beneficiary about how they use that asset. 

As your pension isn’t normally covered by your will, we recommend that all our clients complete an expression of wishes. This states who you would like to receive your pension savings. It doesn’t have to be just one person. It could be any number of people. It’s not legally binding but is still a really important document. When you pass away the pension scheme trustees or the pension administrator will use the expression of wishes to decide what should happen to your remaining pension. If you have more than one pension you’ll need to complete an expression of wishes for each.

Is any inheritance tax payable on limited companies?

If you own your own business or have an interest in a business your estate may be entitled to relief from inheritance tax. That’s called business property relief. It allows you to claim IHT relief on business assets that you own, including shares in any qualifying businesses. 

Not every business or interest in a business qualifies for business property relief. A business that mainly deals in security stocks, land or buildings or holding investments won’t be eligible. 

To receive business property relief you must have owned the business or the business assets for at least two years before your death. Business property relief from IHT is either 100% or 50%, depending on the type of business asset. 

There’s a lot to this area and many caveats with it. So speak to your accountant or your financial advisor about this type of relief 

Is there inheritance tax payable on my farm?

In Northern Ireland, where we are, there are a lot of family farms and agricultural businesses – and the good news is that there is relief from IHT on the transfer of agricultural property. 

This relief is called Agricultural Property Relief and it means that a farm business can be left to the next generation without any great concern for inheritance tax. 

In agricultural or farm businesses it’s common to hand livelihoods down over many generations. Like business property relief, agricultural property relief is available at either 100% or 50% against the agricultural value of the property, depending on the type of property being transferred. 

In this context, property isn’t just buildings, it can be machinery and land. The property in question must have either been occupied by the owner for the purposes of agriculture for two years prior to the gift, or owned by them for 7 years and occupied by someone else for the purposes of agriculture throughout that period. 

Again this is a huge area – there is an awful lot to it and further considerations regarding the occupation and use of the land to determine the rate of relief. So speak to your financial advisor on this, or your accountant.

What else do we need to know about inheritance tax planning?

We’ve only really scratched the surface on this subject – it’s a considered and a very precise process. It cannot be rushed.  So it’s really important not to plan in isolation. IHT planning should be part of an overall strategy – it needs to encompass your lifetime financial goals and assets. 

Parts may be separated and executed at different times. It really is essential to know how IHT could affect you, your relatives or any of the beneficiaries you’ve named for any of your assets. 

Another important piece of advice is to make sure that you stay informed – as you know, legislation and taxation is always changing. Speak to your financial advisor on a regular basis to stay up to date, and know that your arrangements continue to be suitable for the assets that you hold and your potential liability.

The value of investments and any income from them can fall as well as rise and you may not get back the original amount invested.

HM Revenue and Customs practice and the law relating to taxation are complex and subject to individual circumstances and changes which cannot be foreseen.

Tax treatment varies according to individual circumstances and is subject to change.