Pensions and inheritance tax: how to protect your legacy

Inheritance tax (IHT) is a 40% tax payable on whatever you leave behind for your heirs when you die, on estates above a certain value. Your estate with a few exceptions consists of the assets that make up your net wealth at the point of death. So that's everything from your house, to cash in the bank, to your investment portfolio. The bill usually has to be paid by the executor of your estate within six months of your death, or the tax office will start charging interest.

When you summarise it in this way, it sounds pretty brutal, and it's little wonder that it's an extremely unpopular tax. It's bad enough having to contemplate your own mortality without also having to worry about HM Revenue & Customs swooping in to add insult to injury by demanding 40% of your kids' inheritance. And while the number of people who end up having to pay it is small, rising house prices mean that a record number of estates were caught up in the net last year, with the IHT take hitting an estimated £4.7bn in the 2016/2017 tax year. But whatever your own view on IHT a progressive tax on unearned wealth, or an unfair levy on a lifetime's hard work the good news is that there are plenty of straightforward ways to minimise your potential liability, so that you don't end up paying any more than you absolutely have to.

Who has to pay inheritance tax?

Each individual can pass on up to £325,000 when they die without their heirs incurring IHT. If you are married, or in a civil partnership, then you can pass on up to £650,000 between you. However, it's vital to understand that even if you have lived with and had children with a partner without being married, they will not be considered your spouse for IHT purposes. So one of the most important IHT-planning measures you can take is quite simply, to get hitched.

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There is also now an extra IHT allowance for the family home (as if UK property wasn't tax-advantaged enough). The residence nil-rate band (RNRB) as it's called, currently stands at £100,000 per person and will rise to £175,000 by the 2020/21 tax year. This means that as long as you bequeath your main residence to direct descendants (children or grandchildren), then the extra allowance will be deducted from its value for IHT purposes. So, in effect, by 2021, a couple with kids and a house worth at least £350,000 will be able to pass £1m to their heirs, IHT-free (but just to make things far more complicated than they need to be, the RNRB starts to get tapered away for estates note, that's the entire estate, not the individual property worth more than £2m).

"A riskier option is to invest in companies that qualify for business property relief"

Clearly £1m is a significant sum, which is why most people never have to worry about being liable for IHT. However, the risk is that, over time, a combination of cash-strapped governments, fiscal drag (whereby tax thresholds don't rise, even although prices do), and rising house prices in particular, will push increasing numbers of people over the threshold. So what can you do to make sure you're not one of them?

The first option is to give your wealth away before you die. One snag is that you have to survive for seven years after the gift has been made for it to be fully free of IHT. (The tax rate starts to taper after three years). It also has to be a genuine gift you can't "give" your house to your children and then continue to live in it rent-free, for example. However, certain gifts are exempt. You can give away as many "small gifts" (up to £250 per person) as you like. You can also give away another £3,000 a year without it being added to your estate, and you can carry forward any unused allowance for one year (so you could give away £6,000 every second year). You can also make wedding gifts of £1,000 per person, or £2,500 for a grandchild, or £5,000 for a child. And you can also make regular gifts out of your income IHT-free as long as it doesn't impact on your standard of living but it's worth keeping proper records of this to avoid any disputes in case the issue comes up in the process of dealing with your estate.

Passing on your pension

Another option is to make use of your pension (assuming it's a defined contibution DC pension). Money in your pension is excluded from your estate for IHT purposes, so you can pass it on to your heirs free of IHT. Given that you can have up to £1m in a pension before you breach the lifetime allowance, that's a pretty significant inheritance. As a result, if you are at risk of breaching the IHT threshold, it makes sense to avoid drawing down your pension where possible, and use other assets instead such as money saved in individual savings accounts (Isas), for example.

If you have a defined benefit (DB) pension instead (whereby an employer guarantees you an annual payout on retirement, based on your salary and length of service), you can't do this, but you could consider gifting the income away if you don't need it to maintain your standard of living. There is the option of converting your DB pension into a DC one, but that's a complicated decision and may well not be in your best interests (and the current IHT and pension rules are, of course, always subect to change) so take professional advice if you decide that you want to go down that route.

Load up on small companies

A riskier option is to invest in companies that qualify for business property relief (BPR). After you've held the investment for two years, it is entirely free of any IHT liability. To qualify for BPR, a company's main business cannot be investing in other companies (so that rules out investment trusts, sadly) or property, and it cannot be listed on a recognised stock exchange. London's junior market Aim fits the bill here, and as a result, many (although not all) of the stocks listed on it are suitable for building IHT-efficient portfolios.

Obviously, one risk here is that there's no point on investing in stocks purely on the basis of tax efficiency if you then lose a lot of money on the actual investment (you could argue of course that losing 20% on the portfolio is still preferable to losing 40% on the tax liability, but that's probably not the mindset to approach this option with). Investing in equities is risky at the best of times, and Aim is well-known for hosting more than its fair share of duffers, to put it politely. So you have to be extremely picky.

That said, there are some excellent, well-run companies that have chosen to remain on Aim for a wide range of reasons. MoneyWeek regular Richard Beddard has previously written in the magazine about some of his favourite IHT-efficient Aim stocks, which include Judges Scientific (LSE: JDG) and Portmeirion (LSE: PMP). However, if you're not keen to go out and pick your own stocks, several wealth managers offer IHT-efficient portfolio services. You'll need to have a decent-sized portfolio and the fees can be high, but if you're in a position to be concerned about your IHT liability, then this is certainly an option worth investigating.

Other potential options

Beyond this, there are other assets that avoid IHT. Agricultural property is one of the best-known options. However, you can't just buy a cottage in the countryside with some farmland nearby it has to be a working farm. Commercially-managed woodland is also exempt from IHT if held for two years, similarly to Aim stocks.

Obviously, there is political risk here in most of the measures that we've looked at above. Any of the rules governing inheritance could change, and given the mood music in the country right now, and the potential for a new government or two over the next five years, we'd be wary of making any large, expensive, and potentially irrevocable planning arrangements. In addition, if you have a particularly large estate one that's well above the £1m IHT threshold then it's worth seeking out expert advice, because IHT can get complicated quickly, mistakes can be expensive and good advisers can easily be worth their cost. However, the ideas listed above are generally simple to implement for estates that might be on the borderline for IHT.