How Do I Reduce My Inheritance Tax Liability?

If you’re a UK citizen with a UK domicile, IHT is calculated on your worldwide assets. It’s important to note that domicile is different to residency, and the distinction can be very grey. Generally speaking, if you were born in the UK or lived there for more than 15 years, you will be classed as a UK domicile.

For married couples, IHT is typically calculated on a combined basis. When the second person in the couple passes away, it is generally at this point when IHT is calculated and the executor of the estate is required to make payment to HMRC. 

Everyone has a tax free amount (known as a Nil Rate Band) of £325,000. Any estate worth less than this (per person), is free of IHT.

There’s no specific property inheritance tax, and in fact there is actually an additional Residence Nil Rate Band (RNRB) for homeowners of £175,000, as long as the property is worth at least this amount. 

That means that for a couple who own a home worth at least £350,000 (2 x £175,000 RNRB), they can have a total estate of £1 million before being liable for any IHT. To benefit from the RNRB the beneficiaries must be direct descendants and the allowance is tapered down where the estate is over £2 million in value.

For any amount over these thresholds, IHT is charged at a rate of 40%.

So, for example, an estate worth £1.1 million would only be liable for IHT on the £100,000 over the Nil Rate Bands (NRB), meaning there would be a IHT bill of £40,000 payable by the estate to HMRC.

There are also some notable exceptions to this, with pension assets being the most common. As pension funds are technically held in trust, pension assets are not liable for IHT, no matter how large the balance.

It’s very unlikely that IHT is going to be abolished, particularly under a new Labour government. If anything, we can expect IHT to become broader, with fewer ways to reduce the impact and more estates falling within the thresholds.

In simple terms, asset values are growing at greater rates than the nil rate bands. The current NRB of £325,000 hasn’t changed since 2009. If adjusted each year for inflation, the current should now be over £500,000.

While the introduction of the RNRB in 2017 has somewhat offset this, stock prices and property values have increased well in excess. 

The simplest way to reduce your IHT bill is to reduce your estate through gifting. You can give any amount you want, but gifts over the £3,000 annual gifting allowance (per person), are what’s known as Potentially Exempt Transfers (PETs). They get this name, because when the gift is made, they start what you may have already heard referred to as the ‘7 year clock.’

If you survive 7 years after making the gift, it is exempt from IHT. If you don’t, the value of the gift is added back to the estate for the IHT calculation, on a sliding scale based on how many years it’s been.

As well as the annual allowance of £3,000 per person, there are also a number of smaller allowances such as the ability to make regular gifts for things like birthdays and Christmas, as well as some specific exemptions for wedding gifts for immediate family.

Lastly, there is no limit or 7 year clock for gifts that are made out of regular income. So, for example, if you have income streams that pay you £100,000 per year and you genuinely only need £75,000 per year for your own living expenses, you can gift the £25,000 and have it fall immediately outside of your estate. 

As mentioned earlier, pension assets are exempt from IHT. For investors who have other assets they can rely on for their living expenses in retirement, it often makes sense to retain pensions until later in life for this reason. However, this isn’t always appropriate, so it’s an area where personal financial advice is highly recommended.

Trusts aren’t a silver bullet, but they can be a useful tool for investors who aren’t prepared to gift large amounts of money to their family just yet. A trust can be created with children or others as beneficiaries, and you as a trustee. Gifts can then be made into the trust, which starts the 7-year clock, but the trustees retain control over how the funds are invested and distributed.

There are even some trust types which allow you to retain some limited access to the funds in the event that you need them in the future.

Trust rules are very complex, and if done incorrectly, gifts into trust can be classed as Chargeable Lifetime Transfers (CLTs), rather than PETs. This can potentially result in an inheritance tax bill being levied immediately, so it’s a mistake you want to avoid!

There are certain types of investments that are exempt from IHT if they’re held on death and for at least two years. There are many different assets that can fall into this category, with some of the most common examples including:

• Ownership in private companies
• AIM-listed equities
• EIS & SEIS investments

A gift made in your Will to a charity or qualifying community organisation (like a grass roots sports club) is automatically removed from your estate value for IHT purposes. If the charitable gift is at least 10% of your net estate (the amount over the IHT threshold), it also reduces the overall IHT rate you pay from 40% down to 36%. 

Once the various gifting, trust and investment options have been exhausted, it might not be possible to reduce an IHT liability down to zero. A strategy that can be used here is to take out a whole life insurance policy to cover the potential IHT liability.

The cost of the policy should be weighed up with the benefit it will provide, and it’s also important to ensure that the beneficiary is set up to pay into a trust in the correct way, to avoid the sum insured simply being added to the estate.