Introduction
When it comes to leaving a legacy, many people aim to ensure that their wealth is passed down to their loved ones or causes they care about. However, without careful planning, the inheritance tax (IHT) burden can erode much of the wealth you wish to transfer meaning less will be left. The good news is that with the right strategies, you can minimise the impact of IHT, protect your estate, and ensure that your legacy is meaningful, whether that is to help your children, to leave to the dogs shelter, or anything else you care about!
In this article, Ellie Pemberton explores the ins and outs of IHT planning and wealth transfer. Whether you're an individual, part of a family, or a business owner, this guide will help you navigate the complexities of IHT and legacy planning, ensuring your assets are passed down as efficiently and tax-effectively as possible.
What is Inheritance Tax and How Does It Work?
Inheritance tax is a tax on the estate (the property, money, and possessions) of someone who has died, which means whilst it is a tax on your estate you yourself will not be the one paying it! In the UK, IHT applies if the value of the estate exceeds a certain threshold. The amount that is taxed is typically set at 40% of the value over the threshold, which can have a significant impact on the wealth you leave behind.
Who Pays Inheritance Tax?
Inheritance tax is typically paid by the estate of the deceased, meaning it comes out of the total value of the assets before they are passed on to heirs. However, in some cases, the beneficiaries may need to pay a portion of the tax, particularly if they inherit a portion of the estate that exceeds the threshold.
The Inheritance Tax Threshold
Currently, the standard inheritance tax threshold is £325,000. This means that if the value of your estate is below this threshold, your beneficiaries won’t be required to pay IHT. However, if your estate exceeds this amount, the value over £325,000 may be subject to IHT.
There are other exemptions and allowances that can reduce the value of the estate for IHT purposes, which we’ll explore in more detail later.
How Inheritance Tax works: thresholds, rules and allowances: Overview - GOV.UK
Key Considerations for Reducing Inheritance Tax Liability
To avoid the hefty 40% tax on your estate, it’s important to be aware of the key strategies available to reduce your IHT liability.
Spousal Transfers
One of the most effective ways to reduce IHT is by passing assets to your spouse or civil partner. Transfers between spouses are exempt from IHT, meaning that your spouse will inherit your estate without paying any tax. This means if one spouse leaves everything to the other on death, the estate will not have to worry about IHT until the second spouse passes away.
Charitable Contributions
Leaving part of your estate to charity can reduce your IHT liability. If you leave at least 10% of your net estate to charity, you can reduce the rate of IHT on the rest of your estate to 36%. This strategy not only helps reduce tax but can also reflect your personal values and leave a lasting philanthropic legacy.
"Leaving a meaningful legacy isn’t just about passing down wealth—it’s about ensuring that wealth is transferred in the most tax-efficient way possible so your money can go further helping your loved ones or charitable causes. Early planning and understanding your exemptions and allowances is key to reducing the burden of inheritance tax."
Keely Woods – Chartered Financial Planner
IHT Thresholds and Allowances – Reducing Tax Liability
Understanding the various IHT thresholds and allowances available can help you reduce the taxable value of your estate. The below lists some of the main ones:
The Nil-Rate Band
The nil-rate band is the amount of your estate that is exempt from inheritance tax. This band is currently set at £325,000. If your estate is worth less than this amount, no inheritance tax will be due. If your estate exceeds the nil-rate band, the excess may be taxed at 40%.
The Residence Nil-Rate Band
The residence nil-rate band is an additional threshold that applies when passing your home to direct descendants (children or grandchildren). This band can increase the threshold to £500,000. So, for married couples or civil partners, the total IHT allowance could potentially be as high as £1 million if they pass on their home to direct descendants.
Exemptions That Reduce Taxable Estates
There are several exemptions and allowances that can reduce the overall taxable value of your estate, including the annual gift allowance, wedding gifts, and other gifts made during your lifetime. These can all help reduce your estate’s taxable value and lower the IHT bill.
Strategies for Effective IHT Planning
There are numerous strategies you can employ to reduce your estate's IHT liability. The earlier you start planning, the more effective these strategies will be.
- Gifting Assets - One of the most straightforward ways to reduce your estate's taxable value is to gift assets during your lifetime. This can include giving away money, property, or investments. Regular gifts can be a powerful tool in IHT planning, particularly if they fall within the exemptions and allowances. Gifting whilst you are still alive also means you get the see the direct impact your generosity has on others!
- Charitable Donations - As mentioned earlier, leaving a portion of your estate to charity not only supports causes you care about but also provides a tax-efficient way to reduce IHT. Charitable donations can be included in your will and will not be subject to IHT.
- Utilising Annual Gift Allowances - Each year, you are allowed to gift up to £3,000 without incurring any IHT. This is called the annual exemption, and it’s a simple way to reduce the value of your estate over time. If you haven’t used your exemption in one year, you can carry it over to the next year.
- Setting Up Trusts - Trusts are a useful tool for reducing IHT and protecting your assets. By setting up a trust, you can transfer assets into the trust’s name, removing them from your estate. Trusts can be especially useful for passing on wealth to younger generations while retaining control over how and when they access it.
- Investing in Business Relief Qualifying Assets - Business Property Relief (BPR) is a tax relief available on business assets. If you own shares in a business that qualifies for BPR, these assets can be passed down free of IHT, provided certain conditions are met. This is particularly relevant for business owners looking to pass on their company without incurring significant tax.
- Regular Gifts from Surplus Income - You can also make regular gifts from surplus income without incurring IHT, as long as these gifts do not affect your standard of living and are regular. This can include gifts to children, grandchildren, or anyone else you may want to help. These gifts are exempt from IHT if they meet specific criteria, providing a tax-efficient way to transfer wealth.
How Gifting Can Reduce IHT Liability
One of the most effective ways to reduce IHT liability is through gifting. It is also a great way to allow you to see how your generosity can help others. Gifts made during your lifetime, within certain allowances, can be deducted from the value of your estate, reducing the overall IHT burden.
Annual Gift Exemptions
The £3,000 annual exemption is one of the simplest ways to reduce IHT. Each year, you can gift up to £3,000 without it counting towards your estate’s value. If you don’t use your annual exemption, you can carry it over to the next year.
Wedding & Civil Partnership Gifts
In addition to the £3,000 annual exemption, you can also make wedding or civil partnership gifts. These gifts are exempt from IHT up to a certain amount, depending on the relationship between the giver and the recipient. This means not only can you enjoy the wedding, you can reduce your taxable estate at the same time!
The 7-Year Rule
If you make a gift and survive for seven years, it will be exempt from IHT, regardless of the value. However, if you die within seven years of making a gift, the gift will be included in your estate and subject to IHT.
The 10 Percent Rule
If you leave at least 10% of your net estate to charity, you can reduce the IHT rate from 40% to 36%. This is a powerful way to lower your estate’s tax liability while leaving a meaningful legacy.
"Many people overlook the power of gifting in reducing their IHT liability. By taking advantage of annual gifting exemptions and strategically using other methods such as trusts, you can significantly reduce your taxable estate and pass on wealth with fewer tax implications."
Luke James – Chartered Financial Planner
What Steps Should I Take to Protect My Estate?
IHT planning isn’t something you should leave until the last minute. The earlier you start, the more options you’ll have for reducing your tax liability and protecting your estate.
Plan Early - Starting your estate planning early gives you time to consider your options, including gifting, trusts, and charitable donations. The earlier you begin, the more effective your plan will be.
Regularly Review & Update Your Will - Your estate plan should evolve with your life. As your circumstances change such as marriage, the birth of children, or the sale of property it’s important to update your will to reflect these changes. Regularly reviewing your will ensures that your legacy is passed on according to your current wishes.
What Are the Common Mistakes People Make When Planning?
Many people make mistakes when it comes to IHT planning, which can lead to unnecessary tax burdens. Here are some of the most common mistakes:
- Overlooking Exemptions & Allowances: Failing to take full advantage of available exemptions can result in unnecessary IHT.
- Delaying Planning: Waiting until it’s too late to start planning can limit your options and increase the tax burden on your estate.
- Failing to Document Gifts: Not keeping proper records of lifetime gifts can lead to complications when it’s time to settle the estate.
- Not Seeking Professional Advice: IHT planning can be complex, and seeking expert advice ensures that you’re taking the right steps to minimise tax liabilities.
Summary
Leaving a meaningful legacy is a wonderful goal, but it requires careful planning to ensure that your wealth is passed on in a way that minimises the tax burden on your heirs. By understanding the inheritance tax thresholds, utilising exemptions and allowances, and considering strategies like gifting, trusts, and charitable donations, you can significantly reduce your IHT liability. Planning early and seeking professional advice are key to ensuring that your wealth is transferred efficiently and in accordance with your wishes.
Disclaimer: This article does not constitute financial advice. We recommend that you speak to a qualified financial planner for advice tailored to your individual circumstances and goals. Financial markets may go up or down, and you are not guaranteed a return on your investment. Past performance is not necessarily a guide to future performance.
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