Inheritance tax is staying, but here’s how to avoid it

Despite the chancellor’s lack of action, though, there are still ways that you can avoid IHT — if you plan ahead. Here’s what you need to know.

The allowance

The first £325,000 value of an estate is IHT-free — and there is an extra £175,000 allowance on top if the estate is worth £2 million or less and includes a family home that is left to a direct descendant (a child or a grandchild).

Anything left to a spouse or civil partner is IHT-free, and they can also inherit any unused IHT allowance, meaning a couple can pass on up to £1 million tax-free together. Any value in an estate above this, including property, shares and cash, could be subject to tax of up to 40 per cent.

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The £325,000 “nil-rate band” has been frozen since 2009, so more families have been dragged into the inheritance tax net as property and shares have increased in value. If the band had risen in line with inflation, it would be near £500,000 today.

In 2009 someone with an average house worth about £154,500 plus £50,000 worth of shares and £20,000 of cash would have been able to pass on all their assets tax-free using just the nil-rate band, without having to leave their home to a direct descendent. With a typical return on cash and shares since 2009 and the average house price rising to £291,000, those assets would be worth £592,980 today, meaning a potential inheritance tax bill of about £107,200 if only using the nil-rate band, according to the wealth manager Interactive Investor.

It is a perfect example of fiscal drag, where the government is able to bolster Treasury coffers by freezing tax allowances while at the same time offering headline-grabbing tax giveaways, such as the 2p cut to national insurance in the autumn statement.

The cohabiting trap

The freeze in the nil-rate band means that more people, particularly the 3.6 million couples who are not married or in a civil partnership, will pay inheritance tax.

Funmi Olufunwa, 43, who works in financial services, lives with her partner of eight years and their five-year-old daughter, and is worried about inheritance tax.

The couple, who live in Crystal Palace, south London, both owned flats when they met and they now live in Olufunwa’s and rent out the other one. They have insurance that will cover their mortgages if one of them dies but this won’t help with an inheritance tax bill. Both flats are worth more than the nil-rate band.

Olufunwa said: “We are in a committed, loving relationship and we pay the same taxes as anyone else, so why should we be penalised for not wanting to get married?”

The rules on giving

If you give away large chunks of your money and die within seven years, it could still be counted as part of your estate for inheritance tax purposes after you die.

But you get a £3,000 total gift allowance each tax year that you can split between people, and you can also give up to £250 to other people as many times as you want on top of that without that money later being counted as part of your estate.

There’s also a wedding allowance, so that when someone gets married or enters a civil partnership you can give them up to £1,000 (£2,500 if they are your grandchild or great-grandchild, and £5,000 if they are your child) that will be free of inheritance tax.

Graham Nixey and his wife, Susan, have been giving gifts to cut the value of their estate

Graham Nixey, a retired finance director, and his wife, Susan, a retired hospital administrator, are both 65 and have been giving away assets for the past two years to reduce the value of their estate.

They live off self-invested personal pensions held with the investment platform AJ Bell, from which they withdraw an income each year, being careful to stay below the higher-rate income tax threshold of £50,271.

Graham, from Southwold in Suffolk, said: “It is a shame that the chancellor chose not to increase the tax thresholds. We are lucky because we can keep within the basic-rate income tax band by only drawing money from our pensions up to that limit.”

You are also allowed to give away chunks of what is deemed “surplus income”. This is the most underused inheritance tax allowance, according to Helen Morrissey from the wealth manager Hargreaves Lansdown.

The gifts have to be a regular payment, must not affect your standard of living and must come from normal income, not from the sale of assets.

A couple with combined pension and investment income of £80,000 after tax and costs of £60,000 a year could potentially give away up to £20,000 a year with no inheritance tax implications. But you should keep detailed records of any such payments, in case HM Revenue & Customs comes knocking.

The benefit of planning ahead

You can give away much larger sums and bigger assets, such as a house, with no inheritance implications as long as you live for seven years after making the gift.

These are known as “potentially exempt transfers”. If you die within seven years there is a sliding tax scale that determines how much of the gift will be clawed back by HMRC.

Gifts to qualifying charities are also exempt from inheritance tax, and leaving at least 10 per cent of your estate to charity can reduce the overall rate of inheritance tax paid on your estate from 40 per cent to 36 per cent.

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You can give assets, such as shares and property, through a trust and they will fall outside your estate after seven years. This can be useful if you want to reduce your estate but not hand over an asset to a beneficiary who may be too young or not yet be in a position to use it wisely.

You can nominate trustees to be responsible for managing the asset but trusts can be complex and it is worth seeking professional advice because you could end up with a surprise tax bill if it is not set up properly. Placing assets worth more than £325,000 into a trust, for example, could mean an IHT bill of 20 per cent and a6 per cent charge every ten years.

The exemptions

A pension should provide an income for you in retirement, but it can also be a good way to mitigate inheritance tax. Pensions are generally exempt from inheritance tax if you die before age 75.

If you die after you reach 75, your beneficiaries will pay income tax on money they take out of the pension at their usual rate of income tax, but this can be mitigated by withdrawing money gradually.

There was some speculation that this pension benefit would be scrapped, but it survived the autumn statement, and is doubly attractive now that there will no limit on the amount you can save into a pension when the lifetime allowance is scrapped in April 2024.

There are also inheritance tax benefits to some investments, such as shares listed on the alternative investment market (Aim), because many qualify for business property relief once you have held them for two years. Qualifying shares are free from IHT. However, not all Aim shares qualify and HMRC doesn’t publish a definitive list of those that do, which can make this tricky to navigate.

Some advisers offer inheritance-tax-mitigating Aim portfolios but you should not invest in a company simply for tax purposes. A poor investment decision could end up costing you an awful lot more than 40 per cent in inheritance tax.

Or there’s the insurance policy

As a last resort, consider buying insurance that pays out when you die to cover any inheritance tax liability. But be careful, the policy should be written into a trust so that the payout doesn’t form part of your estate, otherwise it could end up being subject to inheritance tax itself.