The ins and outs of inheritance tax

Inheritance tax (IHT) is seen as the most unfair tax in the UK, but reforms could be on the way.

Pre-Christmas cuts to inheritance tax are being considered by Chancellor Jeremy Hunt, the i newspaper reported, amid "better than expected figures on public finances".

It's surprising that the government is considering "tinkering" with IHT, said MoneyWeek, given that it is a big "money maker" for the state.

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The number of inheritance tax receipts is at its highest level in 20 years, according to HMRC data.

In the tax year 2020/21, there was a 17% increase in the number of deaths resulting in an IHT charge compared with the previous year, with 27,000 estates being subject to the charge, according to HMRC. The amount raised from IHT increased by £800 million, or 16%, to £5.76 billion.

Unsurprisingly, a poll by Ipsos Mori for The Daily Telegraph found that 43% of British adults think IHT is unfair. Council tax and fuel duty were considered the next most unfair taxes.

While inheritance tax may be associated with the wealthy, high house prices and a freeze on tax allowances means more families could face a bill when their loved one dies. 

Increasing numbers of people are facing IHT bills, but many people "significantly overestimate their likelihood of having to pay", said The Times.

Who pays inheritance tax?

IHT may be "Britain's most hated tax", said RSM UK, but recent figures from HMRC show only 3.73% of estates actually paid it. 

IHT is charged at a "whopping 40% on all assets above a certain threshold" left behind when someone dies, Zoopla explained. Taxable assets include "anything that has value" including a home, car, savings and possessions. But unlike income tax, there is no sliding scale.

The politics of IHT are controversial, said MoneySavingExpert. The argument is that it "redistributes" inherited wealth via the state so it benefits everyone rather than just "children of the rich".

But critics say tax was already paid when the money was earned, "so to pay tax on it again isn't fair".

There have been a "variety of rumours", said FTAdviser, that the government could increase the IHT thresholds or reduce the IHT tax rate. 

Raising the inheritance tax threshold to £500,000 and removing the residence nil-rate band allowance for a main residence could cost the Treasury £1.4bn per year and prevent around 12,500 families from paying the tax, according to wealth manager Quilter.

One proposal, said The Times, is that Hunt could announce an "intention to phase out the levy". 

However, people do not have to wait for reforms to take place. There are ways to reduce your IHT bill and pass more money on to your loved ones without giving it to the taxman.

Inheritance tax allowances 

Everyone has an inheritance tax allowance of £325,000, which is known as the nil-rate band.

Although this may seem generous, when money and possessions are taken into account alongside a home, this could "push" the value of an estate over the £325,000 threshold, said Property Reporter.

There is also an extra allowance if you leave your home to your children or grandchildren. This is called the residence nil-rate band, and it is currently set at £175,000.

Husbands, wives and civil partners can also leave assets to one another tax-free, regardless of the amount. Making the most of this in your will can save your family a "small fortune", said Which?. It also means that if none of the allowance is used, two parents could pass on £1 million to their children tax-free when they combine the nil-rate band and the main residence allowance.

There is a catch, though, warned NerdWallet. The "benefits" of the residential nil-rate band are reduced on larger estates. The allowance is reduced by £1 for every £2 over £2 million. This means that if you have an estate worth more than £2.35 million "you will not benefit from the additional residence nil-rate band allowance".

How to reduce your inheritance tax bill 

There are many legal ways to "dodge the dreaded 40% 'death tax'", said This Is Money, but it is only worth the effort if you are "certain you are rich enough for it to become a problem for your family".

It is important to make a will, said The Times Money Mentor. If you don't state how you want your assets to be divided, the law decides for you so "even more than necessary could end up going to the taxman".

Spending or giving away your money during your lifetime is also "one of the simplest things you can do" to avoid paying IHT, added Which?, because no tax is due on gifts, as long as a person lives for seven years after giving them. 

If you die within seven years and the gifts are above your tax-free allowance, your estate will pay a reduced tax rate known as taper relief depending how long ago you gave the money.

Giving money to charity, political parties or local sports clubs also reduces your estate's IHT bill. If you leave more than 10% of your taxable estate to one of these groups in your will, the inheritance tax rate for the rest of your estate will fall from 40% to 36%.

ISAs are also a great way of keeping the taxman away from your savings while you're alive, but they're also tax efficient when you die, assuming you are survived by a spouse.

It may also be worth putting more money into a pension because they normally fall outside of a person's estate, said Hargreaves Lansdown, "meaning there's usually no inheritance tax to pay on them".

A pension can be passed on to a beneficiary that you name when you start saving. Any withdrawals your beneficiaries make will usually be free from income tax, but only if you die before age 75.

Another option is to set up a trust. When you put money or property into a trust, said MoneyHelper, provided certain conditions are met, "you no longer own it." Instead, the cash, investments or property belong to the trust and are outside anyone's estate for IHT purposes, although you can decide how and when assets are distributed.

If you are worried about your children or grandchildren wasting the money, you could dictate that they gain access to their trust only when they turn 25.

A life insurance policy can also help cover an IHT bill, said Bestinvest, and "remove some of the uncertainty for beneficiaries", but make sure it is written into trust so that the payout does not form part of the estate or it may be taxed.

"This route offers you peace of mind that your beneficiaries won't struggle with a huge inheritance tax bill when you die," Laith Khalaf, head of investment analysis at AJ Bell, told MoneyWeek, "but you are effectively paying at least part of that bill while you are alive through your monthly premiums, which can be substantial." 

Marc Shoffman is an award-winning freelance journalist, specialising in business, property and personal finance. He has a master’s degree in financial journalism from City University and has previously written for FTAdviser, ThisIsMoney, The Mail on Sunday and MoneyWeek.