When you die, all of the assets you have accumulated throughout your life are added together and may be subject to inheritance tax. In 2020/21 over £5.3 billion was paid in inheritance tax in the UK, some of which will have been a large unexpected expense to some people when they didn’t prepare for the worst.
Inheritance tax can costs your loved ones hundreds of thousands so the more informed you are about the rules, the more equipped you’ll be to legally pass on the most you can. In this post, I’ll run through different tips and strategies to help you understand how to avoid inheritance tax and walk you through everything you need to know.
How Much is Inheritance Tax? Tax-Free Threshold
Before we get started running through ways to avoid inheritance tax, I’ll quickly highlight the inheritance tax rates. In the tax year 2021/22 the threshold for individuals is £325,000 which can be transferred to a spouse or civil partner resulting in a total inheritance tax threshold of £650,000 for couples.
Everything above these tax-free thresholds is taxed at 40%, so quite the incentive to reduce the total pot size, which we’ll cover shortly.
Family Home Allowance – Inherit My Parents’ Home
Since 2015 if you leave your main family home to your direct descendants, children or grandchildren, you can take advantage of an additional ‘residence nil rate band’. This is commonly known as the ‘main residence allowance’ and this is an additional £175,000 tax-free allowance that is on top of the existing £325,000 allowance.
This means that you might not have to pay inheritance tax on the first £500,000 of your estate. Some things to note about this additional allowance.
- The additional £175,000 allowance only applies to estates worth under £2 million
- For estates worth over £2 million, the £175,000 main residence allowance is reduced by £1 for every £2 above the £2 million
Inheritance Tax Rules for Married Couples
For married couples and those in civil partnerships, there are special rules.
- Provided your spouse or civil partner is living in the UK, when you die they are exempt from inheritance tax.
- The inheritance tax allowance for the remaining person then rises by the percentage of the unused allowance. This means together a couple can leave up to £1 million tax-free including their main residence. (2 x £325,000 tax-free threshold plus 2 x £175,000 main residence allowance).
In order to activate this, the executors of your will just need to send certain documents to HMRC, after your death. To see their full guidelines here’s a link to the HMRC website.
Ways to Avoid Inheritance Tax
1. Make a Will
Making a will is an important step in making sure your estate in distributed in the way you want and also makes the process significantly more simple for your loved ones when you die. Without a will, your estate will be distributed according to intestacy rules, effectively a default set of rules that may make you liable to inheritance tax that could have been avoided.
Remember that there is no inheritance tax paid on assets inherited between spouses and this can be used to your advantage.
2. Gift Your Assets – Taxable
There are a number of rules around how inheritance tax is payable on gifts, although when used correctly it can save you a significant amount on the final tax bill.
A gift can be anything of value such as money, property or other assets such as cars or jewellery. This also includes the sale of assets to family members at less than the market value, where the difference is considered a gift.
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3. Gift Your Assets – Tax Exempt
There are certain gifts that are exempt from inheritance tax which can help lower the overall size of the estate, reducing the final tax bill, especially if done regularly over time.
- Gifts up to a value of £3,000 in each tax year are exempt from tax and any unused amount is able to be carried forward to the next tax year.
- Gifts for a wedding or civil partnetship.
- £5,000 to a child
- £2,500 to a grandchild or great-grandchild
- £1,000 to anyone
- Gifts of up to £250 that don’t fall into the above categories (birthday presents etc).
- Gifts to qualifying charities, museums, sports clubs, universities or political parties.
4. Gifts Out of Surplus Income
If you’re in the fortunate position to have surplus income when maintaining your current standard of living, you can gift the excess and it will be exempt from inheritance tax.
There are a few conditions that must be met to qualify for a gift out of surplus income.
- The gift must be made out of your after-tax income being able to demonstrate your living costs are covererd from your income and you are not having to resort to capital.
- The gift must be part of your normal or typical expensiture, ideally form a pattern.
There are also some other best practices, such as writing a letter to keep a record of the intention to make a gift out of surplus income. and establish a pattern of making further gifts. If this could be of benefit, discuss this with a specialist.
5. Put Assets into a Trust
Assets, including property, cash or investments, placed into a trust will not form part of your estate upon death, so will be excluded from inheritance tax. There are certain conditions that must be met and quite a number of options available.
For example, you could set up a trust for your children where they only get access to their trust when they turn 25.
6. Put Assets into a Trust and Still Get Income
You can use an interest in possession trust where you can still take an income from the assets, although with the added benefit of avoiding inheritance tax upon death.
7. Life Insurance
You can take out a life insurance policy equal to the value of your expected inheritance tax bill. This will then effectively offset any inheritance tax payable.
You can also place this within a trust so it will sit and be paid outside of your estate, saving on any further inheritance tax and most likely reducing your insurance premiums.
8. Spend It on Yourself!
Often overlooked as a strategy to reduce an inheritance tax bill, any money above the inheritance tax threshold that is spent is effectively a 40% inheritance tax saving.
This may allow you to live a more fulfilling retirement by being able to spend more than expected. For example, if you’ve always wanted a certain car, travel somewhere extravagant on holiday or upgrade part of your home, this gives you the opportunity to do it with a 40% saving.
If you need any help understanding how much you need to save up for retirement or an example of a retirement budget, make sure to read this post.
Inheritance planning can be a difficult subject, although knowing what options you have available can help ensure you pass on more of your hard-earned money to your loved ones and causes you support.
This post is only intended to be used as guidance and if you need any advice make sure to contact a financial advisor that can give you advice tailored to your circumstances.