Planning your finances can be far from straightforward. It is often said that the more money you have, the more you have to worry about, and this is no more true than when deciding how best to leave your hard earned assets to friends and family, whether this be on death or during your lifetime.
However, it is not a headache which just affects the wealthiest in society. Increasingly the inheritance tax net is catching people with more modest estates. For example in 2011-2012 inheritance tax was charged against almost 16,000 estates, but if the current tax thresholds remain the same then by 2020 this figure is expected to rise to 56,100. The reason for this upsurge is due mainly to the forecasted increase in house prices, which will push up the value of what people own.
‘Estate planning’ is therefore becoming more widespread and progressively more important as a means of leaving larger sums for loved ones and less for the taxman.
Before looking into how best to reduce or even completely avoid an inheritance tax bill, it is necessary to briefly discuss when it is charged.
When do we become liable to pay inheritance tax?
The answer is surprisingly often. Essentially, whenever property of value (e.g. money) leaves an estate in a transfer which is not exempted, inheritance tax (IHT) may be chargeable. Transferring assets following a death is of course the most common occasion for IHT to be charged, but even making gifts during a lifetime can give rise to a potential charge to IHT. So why are we not paying IHT more regularly?
The main reason is that when we make a gift to another person during our lifetime, IHT would only be charged against our estate if we died within seven years of giving away the asset. Since there is a chance that it will be exempt from IHT, a gift to another person is called a Potentially Exempt Transfer (PET). As an example, if I give £20,000 to my sister on 1st September 2015, I would have made a PET on that date. If I lived past 1st September 2022, then no IHT would be charged on this sum because I have survived the requisite seven years. However if I died before 1st September 2022, then the administrators of my estate would have to pay a certain amount of inheritance tax on the £20,000 gift (unless it was all covered by my nil rate band – see below – in which case no IHT would be payable but my nil rate band would be reduced by £20,000).
How can we reduce our IHT bills on death?
To answer this, let us first look at the cards in our deck. We are each entitled to an array of exemptions and reliefs which may be applied to reduce any IHT we may be liable for.
– The first is the nil rate tax threshold alluded to above. We are each allowed to dispose of £325,000 worth of assets in our lifetime as we wish without needing to pay any IHT.
– Additionally, if the value of a gift falls within normal expenditure of our income, it will be exempt from IHT. This applies to people who are earning enough to cover the value of the gift without causing a loss to the value of their estate – i.e. dipping into their savings. Conversely, it means retired and unemployed people are at more risk of making a PET.
– We each also have an annual exemption of £3000. This means if we can afford to do so, we can give away up to £3000 per year without making a PET and without nibbling into our nil rate band allowance. In a complicated twist, on death administrators of our estates can in fact offset our £3000 exemption against any PET in the year it was made if it has now become chargeable (made within seven years). This works to leave more of our nil rate band untouched.
However, perhaps the most effective exemption is the spousal exemption. A married person or a civil partner can give an unlimited sum (i.e. all of their property) to their spouse without paying any inheritance tax or using up any of their nil rate band at all. In addition, the receiving spouse can add their partner’s unused nil rate band to their own, meaning that spouse could dispose of up to £650,000 without needing to pay any IHT. This means if you are a widower and your spouse left everything to you, or at least did not give more than £325,000 to persons other than yourself (except charities, which are also exempt recipients) then you will have whatever amount of the allowed £325,000 which was unused in addition to your own remaining band to help reduce any IHT liability on your own death.
More advanced techniques may be considered too. For example, it is possible to write a life insurance policy on trust for the benefit of someone other than yourself. This is advantageous because by writing it on trust, the financial pay-out does not go into your estate on death. Instead it goes to someone else. Since it does not form part of your estate, there is no inheritance tax to pay on it.
To conclude, this article has unfortunately barely scratched the surface of a complex area of law which more and more people are being forced to consider. It is therefore strongly advised that professional estate planning advice is sought prior to making any decisions on distribution of assets in order to leave greater financial support for loved ones.