How to avoid inheritance tax

PHS Team

21 Dec, 2024

Inheritance tax impacts how much of your property is given to your heirs after your death, it can be a major question for many families. The valuation of a property that is above the nil-rate band, which is presently set at £325,000, is subject to 40% IHT in the UK. This frequently asks the question, "How can I avoid or lessen this tax burden?"

Therefore, there are effective strategies to minimise inheritance tax. By making gifts during your lifetime, utilising exemptions, and establishing trusts, you can importantly lower the amount owed. Understanding these options not only helps preserve your wealth but also ensures that more of your assets are passed on to your loved ones. In this blog, we will look at practical ways to navigate inheritance tax and protect your property for the future.

What Is Inheritance Tax

An inheritance tax is a tax on the transfer of wealth from one generation to another. It applies to the total value of a property after deducting any debts or liabilities. Understanding how IHT works is important for effective financial planning, as it can completely affect the amount your inheritor receives.

Importance of Property Planning

• Preserve Wealth: Effective property planning helps protect your assets from unnecessary taxation.
• Reduces Family Burden: Planning can ease the financial stress on your loved ones during a difficult time.
• Ensures Wishes Are Honored: A well-structured plan ensures that your assets are distributed according to your wishes.
• Maximises Exemptions: Proper planning allows you to take full advantage of available exemptions and reliefs.

Understanding Inheritance Tax Thresholds

Understanding the thresholds for inheritance tax (IHT) is important for effective property planning. The Nil-Rate Band (NRB) is the first key threshold to know. Currently set at £325,000, this means that if your property value is below this amount, no inheritance tax will be owed. 

For properties exceeding this threshold, only the amount above £325,000 is subject to a 40% tax rate. For Example, if your estate is valued at £500,000, only £175,000 would be taxed.

In addition to the NRB, there’s the Residence Nil-Rate Band (RNRB), which provides an extra tax-free allowance when passing on your home to direct descendants, such as children or grandchildren. Introduced in 2017, the RNRB currently stands at £175,000 per person. This means that a couple can potentially pass on up to £1 million without suffering IHT if they leave their home to their children. 

However, it's important to note that the RNRB begins to narrow off for property valued over £2 million, reducing the potential benefits for larger properties. Understanding these thresholds can completely impact how much of your property is passed on tax-free.

Ways to Reduce Inheritance Tax

The following are the Strategies to reduce inheritance tax: 

Gifting During Your Lifetime

One of the most effective ways to reduce inheritance tax (IHT) is by gifting assets while you are still alive. This strategy not only allows you to see your loved ones benefit from your goodness but also reduces the value of your property, potentially lowering IHT liabilities.

Types of Gifts: Exempt Transfers vs. Potentially Exempt Transfers

There are two main types of gifts: Exempt Transfers and Potentially Exempt Transfers (PETs). Exempt transfers include small gifts of up to £250 per person each year and an annual exemption of £3,000 that can be carried over if unused. Pets, on the other hand, are gifts that may become exempt from IHT if you survive for seven years after making them.

The Seven-Year Rule

According to the Seven-Year Rule, a gift will not be considered part of your property for IHT purposes if you give it and then pass away within seven years. The gift is subject to IHT if you die within this time frame, though, using a sliding scale called taper relief, which lowers the tax due the longer you live after making the gift. For example, gifts given three to four years before death are subject to a 32% tax rate, whereas gifts given six to seven years before death are only subject to an 8% tax rate. 

Utilising Spouse and Civil Partner Exemptions

One of the most effective ways to reduce inheritance tax (IHT) is by taking advantage of the exemptions available for spouses and civil partners. Transfers between spouses are exempt from IHT, meaning you can pass your assets to your partner without suffering any tax liabilities. This allows you to effectively maximise your property’s value.

Transfer of Nil-Rate Band

If one spouse passes away and does not fully utilise their nil-rate band (NRB), the unused portion can be transferred to the surviving spouse. This means that upon the death of the surviving spouse, they can benefit from a combined NRB of up to £650,000. This transfer can completely reduce the taxable value of the property.

Benefits of Leaving Assets to a Spouse

Leaving assets to a spouse not only avoids immediate IHT but also allows for potential growth in value without tax results during their lifetime. This strategy can provide financial security for your partner while ensuring that your property is preserved for future generations. By planning wisely, you can minimise IHT and protect your family's wealth.

Establishing Trusts

Setting up a trust is an effective strategy to reduce inheritance tax (IHT) liability. By transferring assets into a trust, they are often removed from your property, which can help minimise the amount subject to IHT. This allows for better control over how and when your assets are distributed to beneficiaries.

Types of Trusts and Their Benefits

1. Discretionary Trusts: These trusts allow trustees to decide how to distribute income and capital among beneficiaries, providing flexibility based on their needs.
2. Interest in Possession Trusts: Beneficiaries receive income from the trust during their lifetime, but the capital is passed on to others after their death, ensuring financial support while preserving assets for future generations.
3. Bare Trusts: The simplest form, where beneficiaries have a right to the assets once they reach adulthood. This type is straightforward and often used for minors.

The Role of Trustees

Trustees are responsible for managing the trust's assets and ensuring that they are distributed according to the terms set by the trust creator. They have more examples of duty to act in the best interests of the beneficiaries, making their role crucial in effective estate planning and tax reduction strategies.

Charitable Donations Overview

Making charitable donations is a powerful strategy to reduce your inheritance tax (IHT) liability. When you leave gifts to registered charities in your will, these amounts are exempt from IHT, meaning they do not count towards the value of your property.

• How Charitable Gifts Reduce Tax Liability

By donating to charity, you can effectively lower the taxable value of your property. For example, if your property is valued at £500,000 and you leave £50,000 to charity, only £450,000 will be subject to IHT. This can significantly reduce the amount your heirs may need to pay.

• The Impact of Leaving a Percentage to Charity

Additionally, if you leave at least 10% of your net property to charity, you can benefit from a reduced IHT rate of 36% on the remaining property value instead of the standard 40%. This means that not only do you support a cause you care about, but you also decrease the overall tax burden on your heirs. 

Making a Will

Having a will is important not just for clarity but also for effective tax planning.

Importance of Having a Will

1. Clarity of Wishes: A will clearly outline how you want your assets distributed, reducing confusion among heirs.
2. Legal Protection: It guarantees that your desires are enforceable by law, averting disagreements that would occur in the absence of a will.
3. Guardianship: If you have children, a will allows you to appoint guardians, ensuring they are cared for by someone you trust.

How Wills Can Help Minimise Inheritance Tax

1. Tax Planning: A well-structured will can incorporate tax-efficient strategies, such as setting up trusts or designating beneficiaries in a way that minimises tax liability.
2. Utilising Allowances: By clearly stating your intentions, you can make the most of available allowances like the Nil-Rate Band and Residence Nil-Rate Band.
3. Gifting Strategies: A will can facilitate lifetime gifts or specify charitable donations that reduce the taxable value of your property, ultimately lowering the inheritance tax owed.

Equity Release and Its Implications on Inheritance Tax

Home equity is important in property planning. Home equity refers to the portion of your home that you own outright, which can be accessed through equity release. This process allows homeowners to unlock cash from their property without selling it, providing financial flexibility while potentially reducing the overall value of the property. By lowering the property’s value, equity release can help minimise inheritance tax (IHT) liabilities for beneficiaries.

Pros and Cons of Equity Release

Pros:

• Access to Cash: Provides tax-free cash for immediate needs or expenses.
• Reduced Estate Value: Lowers the taxable value of the property, potentially decreasing IHT.
• Retain Home Ownership: Allows you to continue living in your home while accessing funds.

Cons:

• Reduced Inheritance: The amount available for heirs may be completely less due to the equity released.
• Interest Accumulation: Compounding interest can increase debt over time, affecting the property’s value.
• Impact on Benefits: This may affect eligibility for certain state benefits due to increased income or asset levels.

Other Reliefs and Exemptions Available

In addition to the main inheritance tax thresholds, several reliefs and exemptions can help reduce your tax liability. Business Relief is a complete option that can offer up to 100% relief on the value of eligible business assets when they are transferred to heirs. Accordingly, if certain requirements are satisfied, your beneficiaries might not be required to pay inheritance tax on assets you own, such as a business or stock in a corporation.

Another important relief is Agricultural Relief, which offers similar benefits for agricultural property. If you own farmland or agricultural buildings, this relief can also provide up to 100% exemption from IHT, ensuring that your agricultural legacy is preserved for future generations.

Furthermore, Community Amateur Sports Club (CASC) Relief is that it exempts some sports clubs from inheritance tax upon death. As a result, clubs and their members pay less in taxes, and community sports programs are encouraged to continue. Having a thorough understanding of these reliefs can greatly influence your property planning approach.

To effectively reduce inheritance tax, consider these key strategies, make lifetime gifts to reduce your property’s value, utilise the nil-rate band and residence nil-rate band for tax-free allowances, establish trusts to protect assets, and leave charitable donations to lower your tax bill. By implementing these approaches, you can ensure more of your wealth is preserved for your loved ones.

To assist clients in navigating the complexity of property planning, PHS accountants specialise in inheritance tax services. We offer professional guidance on reducing tax obligations by employing efficient tactics including trusts, gifting, and using applicable exemptions. By evaluating your financial status, we can create a customised strategy that optimises your tax-free allowances and ensures that more of your money is kept for your loved ones. Book our Free consultation service to know more about this tax. Furthermore, We help you prepare and submit the required tax paperwork, which makes the procedure easier and less stressful for you during a trying time.

Disclaimer:

The information provided on this website is for general informational purposes. Inheritance tax rules and exemptions can vary depending on individual situations and may be subject to change. PHS Associates is a qualified financial advisor, and tax professional, for personalised advice tailored to your needs.