Inheritance tax planning is critical to maximising the amount that can be passed on from your estate to your beneficiaries.
In this guide, we look at whether it is possible to avoid, or at least reduce, inheritance tax so as to minimise the amount of IHT payable.
What is inheritance tax?
Inheritance tax is the tax payable on the net value of your estate when you pass away. Your estate comprises any money, property and possessions once your funeral expenses, any estate administration costs, as well as any debts and liabilities, have been fully paid.
It is only once all debts and liabilities have been discharged, including any liability to inheritance tax, that the residue of your estate can be distributed in accordance with the terms of your Last Will and Testament or, in the absence of a Will, under the intestacy rules.
Inheritance tax is payable directly to HMRC by either your executor(s), assuming you die with a valid Will in place, or by your administrator(s) if you die without making a Will, known as dying intestate. An administrator is anyone appointed to take responsibility for administering and distributing your estate, in exactly the same way as an executor.
However, any individuals acting on your behalf after you die are not personally liable to pay any inheritance tax due, where the funds from your estate will be used to discharge any inheritance tax liability. Equally, your beneficiaries will not typically pay tax on any money, property and possessions that they inherit from you, although those assets will count towards the value of your estate to establish if any inheritance tax is due in the first place.
How can you avoid inheritance tax?
Paying inheritance tax, where this falls due on any amount over and above the applicable nil rate bands, cannot be avoided once you have died. However, by understanding how inheritance tax works, this can be key to effective estate planning during the course of your lifetime. By planning ahead and preparing for the point at which you will pass away, there are several ways in which you can legally reduce your liability to inheritance tax, in this way maximising the legacy that you leave behind.
Strategies to reduce inheritance tax
The various different kinds of strategies that can be used to avoid inheritance tax include use of the married couple’s allowance and the rules around lifetime gifts.
The married couple’s allowance
For those of you who are either married or in a civil partnership, by law you can pass your money, possessions and property to your husband, wife or partner entirely tax-free. Further, if your estate is worth less than the applicable threshold(s), any unused threshold can be added to the threshold of your spouse or civil partner when you die, or vice versa.
The net effect of these rules is to effectively double the amount of money that a surviving spouse or civil partner can leave behind tax-free on their own death. Consequently, as the thresholds currently stand, both married couples and civil partners can pass on up to £1 million tax-free where a qualifying residential property is included within their estate.
During your own lifetime, there are various allowances that you can use to give tax-free gifts. This includes an annual inheritance tax exemption of £3,000, allowing you to give away this amount in each tax year without this being added to the value of your estate on death. Additionally, some gifts do not count towards this annual exemption, including gifts as between spouses, unlimited small gifts each tax year of up to £250 per person, birthday or Christmas gifts from your regular income, as well as gifts to charity.
Additionally, any gift that falls outside of these exemptions that are made within more than 7 years outside of the date of death will be entirely tax-free, regardless of their value. Known as “potentially exempt transfers” (PETs), a PET is a gift that is potentially exempt from inheritance tax, but only if the gift was made at least 7 years before you die.
For gifts given in the 3 years prior to your death, these will be taxed at the full rate of 40%. However, for gifts given in the 3 to 7 year period before your die, these will be taxed on a sliding scale known as taper relief, where this can vary from between 32% to as little as 8%. It therefore follows that the longer you live having made a PET, the more likely your loved ones will avoid inheritance tax on that gift. The sliding scale is as follows:
- 3 to 4 years between gift and death: 32% rate of tax on the gift
- 4 to 5 years between gift and death: 24% rate of tax on the gift
- 5 to 6 years between gift and death: 16% rate of tax on the gift
- 6 to 7 years between gift and death: 8% rate of tax on the gift
- 7 or more years between gift and death: 0% rate of tax on the gift.
Importantly, taper relief only applies if the total value of gifts that you make in the 7 years before you die is over the £325,000 inheritance tax-free threshold.
Can you avoid inheritance tax on property?
There are again a number of ways in which inheritance tax can be avoided on property, including leaving the family home to a spouse or civil partner, where this will be entirely tax-free. Equally, you could bequeath any property to a lineal descendant, in this way taking advantage of the residence nil rate band, a provision introduced by the UK government as a means of allowing individuals to pass on their family home after they die. Importantly, the residence nil rate band is not an exemption or relief on any residence itself, but rather it is set off against the entire estate, provided the property is a qualifying residential interest.
You may also want to consider gifting your home before you die, where your estate may benefit from the 7-year rule under lifetime gifts, although this rule does not apply to gifts with reservation. This refers to a gift which you continue to benefit from. As such, if you continue to live in the property, this will still count towards the value of your estate, unless you pay rent at the going rate, such that you will not be deemed to have retained a benefit.
An alternative option would be to place your property in trust where, for the purposes of any tax liability, the property will no longer form part of your estate. However, some types of trust can be subject to their own separate tax regime, where expert advice should always be sought from an estate planning solicitor when it comes to trusts and estate planning.
What is the inheritance tax rate?
Inheritance tax will be payable in accordance with the inheritance tax rate at the time of your death. As the law stands in the UK, inheritance tax will be payable on your estate, typically at a rate of 40%, on anything over and above the applicable threshold(s).
However, there are certain circumstances in which the 40% rate may be reduced. For example, your estate may be liable to pay a reduced inheritance tax rate of 36% on certain assets if you gift 10% or more of the net value to charity in your Will. Equally, there will be an even lower rate on any lifetime gifts made, in some cases as little as 8%, although the taper relief available on lifetime gifts are discussed in more detail below. Importantly, where inheritance tax is payable on lifetime gifts, this will become payable by the recipient of that gift. This is in contrast to any beneficiaries under the provisions of your Will or the rules of intestacy, where the responsibility for paying inheritance tax lies with the estate.
Any inheritance liability must be paid by the end of the sixth months following the date of death, for example, if the deceased passed away in April, the tax due must be paid by 31 October. HMRC will charge interest if this is not paid by the due date.
What are the inheritance tax thresholds?
Inheritance tax will only become payable when the net value of your estate exceeds any applicable threshold(s), including the standard nil rate band and residence nil rate band.
The standard nil rate band
As the law currently stands, each individual is entitled to an inheritance tax allowance of £325,000. This is known as the standard nil rate band and represents the minimum sum of money that you can leave behind to loved ones tax-free. This allowance will not only apply to any beneficiaries named under a Will, but also to your next of kin if you die intestate.
The nil rate threshold of £325,000 has been fixed at this rate since the tax year 2009/10 and will remain at this rate until 2027/28. This means that for at least another 5 years, inheritance tax will only be payable if the net value of an estate is more than £325,000.
For example, if your estate is valued at £500,000, inheritance tax will be payable on the additional £175,000 (£500,000 – £325,000), where tax will be charged only on the portion of the estate that exceeds the £325,000 threshold. Assuming a rate of 40%, this means that the inheritance tax bill for your estate would be £70,000 (40% of £175,000).
Importantly, however, even if your estate is worth less than the threshold, and therefore not subtext to inheritance tax, your executor(s) or administrator(s) will still need to declare the value of the estate to HMRC as part of their administrative duties after you die.
The residence nil rate band
In addition to the standard nil rate band, there is a residence nil rate band. Introduced in 2017, this is an extra tax allowance, aimed at residential property owners and designed to significantly increase the amount of wealth that you are able to leave behind free of tax.
Initially set at £100,000 in 2017/18, this residence relief has been gradually phased in since then, currently standing at £175,000. The residence nil rate band has remained at this level for the tax years 2020/21, 2021/22 and 2022/23. It will also continue to stay at this level until 2027/28. This means that since 2020, it has been possible to pass on as much as £500,000 without an estate incurring any inheritance tax liability whatsoever.
However, unlike the standard nil rate band, which is applicable to all estates, there are strict criteria when it comes to who can qualify for the residence nil rate band where, immediately prior to your death, your estate must include a “qualifying residential interest”. You do not have to be residing in the property at the point at which you pass away, although it must be a property that at some stage you have used as a residence.
The residence nil rate band rules also require that the qualifying property must be “closely inherited”. As such, for your estate to benefit from this additional threshold, the property — or a share of it — must be left as part of your estate to a direct descendant. A direct descendant is any lineal descendant, such as a child or grandchild, but can include any adopted, foster or stepchildren, or children for whom the deceased was a court-appointed guardian. It can also include the spouse or civil partner of a lineal descendant, including any widow(er) or surviving civil partner of that descendant, provided they have not got married again or entered into a new civil partnership. However, the rules do not apply to lineal ancestors, such as parents or grandparents, nor do the rules allow siblings, or nephews and nieces, to benefit from this tax relief if you leave your home to them.
Importantly, a taper rule will also reduce the amount of the residence nil rate band by £1 for every £2 that the net value of an estate is more than £2 million. As such, by the time your estate reaches £2.25 million, you will no longer benefit from this allowance.
Avoiding inheritance tax FAQs
What is the 7 year inheritance tax loophole?
This refers to the rule that any gift made within a person’s lifetime will be exempt from inheritance tax, provided this is made more than 7 years outside of the date of death.
Can I put my house in my children's name to avoid inheritance tax?
It is possible to gift your home to your children, although by continuing to live there without paying rent at the full market value will mean the property will still form part of the value of your estate.
Can I put my house in trust to avoid inheritance tax?
Putting a house in trust is one of the ways that can be used to avoid inheritance tax, although the trust property may be subject to the other types of tax. As such, expert legal advice should always be sought.
Can I put my house in trust to avoid inheritance tax UK?
You can put a house in trust to avoid inheritance tax, although this can attract different tax liabilities. By seeking estate planning advice, you can explore the other ways of minimising the liability of your estate to inheritance tax.
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal or financial advice, nor is it a complete or authoritative statement of the law or tax rules and should not be treated as such.
Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission.
Before acting on any of the information contained herein, expert professional advice should be sought.