5 quick tips to help reduce inheritance tax

How to minimise Inheritance Tax: 5 quick tips

What kind of legacy do you want to pass on to your children?

Most of us want to leave our loved ones with happy memories of precious time spent together. If we own wealth, then we want to be able to give as much as possible to the people who mean the most to us.

To do that, you need to navigate your way through the complex world of inheritance tax (IHT). All of us need to pay our fair share, but none of us should have to pay more than is necessary.

Fortunately, there are some great strategies you can use to reduce your IHT liability.

Inheritance Tax: A quick overview

Here are some of the important IHT rules in place for 2021-22:

When you add up the total value of your estate (property, your car etc.), any amount over £325,000 is taxed at 40%.

There is a new ‘residence nil rate band’ which allows you to reduce your IHT bill if you leave your residential property to a direct descendant (e.g. your son). In 2021-22, this amounts to £175,000.

So, suppose your home is valued at £380,000 and you leave it to your daughter. Assuming this is the total value of your estate, then you shouldn’t incur any inheritance tax.

If, however, your home is valued at £800,000 and you leave it to a direct descendant, then this would likely attract inheritance tax. This is because £300,000 of the house value is over your £500,000 tax-free threshold (i.e. £325,000 plus the nil rate band, which is £175,000).

5 steps to help reduce IHT

1. Consider your spouse/civil partner

Under English law you can leave anything to your spouse or civil partner without incurring inheritance tax. If you’re living together but unmarried or not in a civil partnership, then unfortunately this benefit does not extend to you (even if you have children).
Your spouse can also add any of your unused IHT allowance to their estate. So, if when you die you haven’t used any of your £325,000 allowance, your spouse or civil partner can add this to their own £325,000.

The same logic applies for any unused residence nil-rate band. So, in 2021-22 this effectively means that your surviving spouse or civil partner could theoretically pass on a £1,000,000 home to your direct descendants when he/she dies:

Spouse A (£325,000 + £175,000) + Spouse B (£325,000 + £175,000) = £1,000,000

2. Use pension planning

Your pension is a secret weapon to minimise your IHT liability. That’s because pensions are not treated as part of your estate for IHT purposes when you die.

If you have a defined contribution pension then your direct descendants can claim the whole pot tax-free within two years. The only condition is that you must have died before the age of seventy-five!

If you die after this age, then your beneficiaries can still access the pension pot and it will not face inheritance tax. However, whoever draws from it will have to add the amount to their own Income Tax bill.

So, by planning ahead carefully you can actually build up your pension in order to pass on more wealth to your loved ones.

One important caveat is that final salary pensions and defined benefit pensions usually can’t be inherited by people other than your spouse. Even then, the income and benefits they receive are likely to be lower.

3. Consider life insurance

Sometimes it simply isn’t possible to avoid IHT. In these cases, it might be worthwhile to take out a life insurance policy which will pay the bill when the time comes.

Provided this policy is written into a trust, the insurance payout should not add to the value of your estate. You should carefully consider your options with one of our qualified financial advisers, as these policies can be expensive if you are older and in poor health.

Sometimes, the total insurance premiums will be less than the IHT payout. Other times, it can actually be cheaper to find ways to reduce your IHT bill, and then pay it.

4. Give it away

You can donate up to £3,000 per year without incurring tax. This can be a great way to reduce your IHT bill.

Over ten years, for instance, you could give £30,000 away tax-free to your children and grandchildren - an amount which might otherwise have faced IHT had it all gone to them later.

There are other useful caveats too. You can make wedding gifts worth up to £5,000 (per parent) to your children, and you can donate as much as you like to charities without incurring IHT.

In fact, if your will leaves more than 10% of your estate to charities, then your estate might not face the 40% IHT rate. Instead, you might qualify for IHT at 36%.

Not only does this put your wealth towards a good cause, it could also dramatically reduce the total amount you have to pay to the taxman.

5. Set up a trust

Some people believe that you can put all of your estate into a trust, and you will then not face any IHT. Trusts can be a great way to reduce IHT, but unfortunately it’s not that simple.

A trust allows you to put your estate into the hands of a trusted group of people (the “trustees”). These people then legally own and control the assets, with the intention of eventually passing them on to your beneficiaries in the timing and manner you have stipulated.

You can reduce your IHT by gradually moving your assets out of your estate, into a trust. Over seven years, the IHT you pay on these assets will gradually decline. If you die within this time, then the assets in the trust might therefore be taxed at a lower rate.

Please note that IHT planning is not regulated by the FCA but that the underlying products may be.  You should always take advice before entering into investments.

Our financial advisers help private clients grow and protect their family wealth through retirement planning, life assurance, mortgage advice and wealth management.

Get in touch today to book a free, no-commitment financial consultation with one of our team.

You can also find out more by visiting our comprehensive IHT web resource