Inheritance tax is being paid by more people and at higher amounts. Plus the rules are changing meaning a fresh wave of families could end up with a bill. But there are ways to ensure more of your money can stay with your loved ones.
Inheritance tax (IHT) is charged at a rate of 40% on individual estates worth more than £325,000 (also known as the nil-rate band). But this has been frozen since 2009, with the effect of dragging more people into the IHT net.
There is also the “main residence nil-rate band” – currently £175,000 – which exempts all or part of the value of the family home from IHT provided the beneficiary is a child or grandchild.
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There's no inheritance tax to pay on gifts between spouses or civil partners, and if your estate is worth less than your threshold, any unused threshold can be added to your spouse or civil partner’s threshold when you die.
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In effect, this means most homeowners can pass on up to £1 million free of inheritance tax (though estates over £2 million won’t have access to the full residence allowance due to a taper).
These allowances have been frozen, and neither are due to rise until 2031. According to analysis by AJ Bell, if both the nil rate band and residence nil rate band were indexed to inflation, the combined total would now stand at around £1.6 million.
However there are steps you can take during your lifetime to ensure more money goes to your loved ones and not the taxman – one way to reduce an inheritance tax bill and significantly improve the finances of the younger generation is to give away money while you are still alive.
Ian Dyall, head of estate planning at wealth management firm Evelyn Partners, comments: “A growing number of estates are finding themselves just the wrong side of the frozen nil-rate band of £325,000, so even modest lifetime gifts could come in useful as a way of saving executors and beneficiaries the rigmarole and expense of settling IHT before probate.”
What to consider before gifting
Before you start giving away your money, think about how much you will need yourself in retirement.
You should only give away what you can afford to lose; don’t risk your retirement or money to cover future care costs.
Anything you give away will not count towards a future IHT bill, provided you live for seven years after the gift.
But there are also gifts that become immediately free of IHT, you just need to know the limits and rules around this.
What gifts are exempt from inheritance tax?
Gifts of any value between UK-domiciled spouses and civil partners are free from inheritance tax.
Lesley Mackintosh, founder of Independent Women, a community of financial advisers, adds that the same is true for gifts to charity, as they are always IHT-free.
“Your gift can make a significant difference in others’ lives while also reducing your potential IHT bill,” she said. An estate can pay inheritance tax at a reduced rate of 36% (down from 40%) on some assets if you leave 10% or more of the “net value” (meaning the estate’s total value after any debts) to charity in your will.
In terms of giving to other people, such as children, grandchildren, friends or other relatives, monetary presents can be free from tax if they fall within one of the following allowances.
Annual exemption
Total gifts made by you in a tax year are less than £3,000 – or £6,000 for a couple. You can also carry forward any unused £3,000 allowance from the previous tax year, making financial gifts of up to £6,000 possible – or £12,000 for a couple.
Small gift allowance
You can also make a series of £250 gifts to any number of individuals each tax year – as long as you haven’t used another allowance for the same person. If you gift £250 to six people each year (£1,500), over 20 years you could gift £30,000 tax-free, potentially cutting your IHT bill by £12,000, according to calculations by investment platform interactive investor.
“It’s surprising how much even small gifts can add up over time. And when they fall within the IHT gifting rules, they can result in significant tax savings,” said Craig Rickman, personal finance editor at interactive investor.
Birthday or Christmas gifts from regular income are exempt from inheritance tax.
Gifts for marriage or civil partnerships
Money can also be given as a gift tax-free to celebrate a marriage or civil partnership, of up to £5,000 from each parent, £2,500 from each grandparent and up to £1,000 from any other person. These do not use up any of the other allowances.
Regular payments from surplus income
You can also give gifts out of surplus income, via the “normal expenditure out of income exemption”, or “gifts from surplus income” rule. These gifts must be “regular” in nature, made from income rather than capital, and cannot affect the donor’s standard of living. It means that once you meet your usual living expenses, you can give away income that’s left over.
Sarah Coles, head of personal finance at AJ Bell, said: "In order to qualify under this rule, the money needs to come from actual income – like earnings, pensions, rent, interest or dividends. You can’t dip into savings or investments.
“After making the gifts, you must still have enough income available to maintain your usual standard of living. You can choose to meet some expenses from savings, but the exemption only applies if your remaining income would have been sufficient to cover them.”
You also need to establish a regular pattern of gifts and keep specific records – including details of the regular gifts, the recipient, where the money is coming from, your usual expenses and the surplus income you have.
It can be useful to keep annual records using the income and expenditure format in HMRC’s IHT403 form, said Coles.
“This will give your personal representatives the information they need to claim the exemption after your death. The gifts need to be regular, but they don’t need to be monthly. They can be made less frequently and still qualify as long as it’s clear they’re for the same person and the same purpose.”
Make sure you keep a record of any cash gifts – this is important as it will help your executors in the future and assist your estate passing through probate as quickly as possible to the people you intend it.
How does the seven-year inheritance tax rule work?
If you intend to give money that exceeds the above gifting rules – for example, £10,000 from your savings as a present for a granddaughter to help her buy a property – then the seven-year rule applies.
This means the gifts are referred to as “potentially exempt transfers”. If you die within seven years, the nil-rate band is reduced by the value of the gifts (so in a sense they are counted as never having left the estate), and tax on assets above the threshold will be due at up to 40%.
Dyall, from Evelyn Partners, explains: “We say ‘up to’ because if the gifts put together exceeded the nil-rate band then taper relief can apply, which reduces the tax paid on older gifts. If there were three to four years between the date of gift and death, the IHT rate lowers to 32%, while at six to seven years the rate falls to just 8%. All of which means that large gifts exceeding the nil-rate band can reduce an IHT liability even if they fall foul of the seven-year rule.”
What to do with financial gifts
Think about where the money that you are gifting is going.
Will it sit in your loved one’s savings account? If so, beware of the recipient having to pay income tax on their interest, if it breaches their personal savings allowance.
Mackintosh comments: “To avoid an income tax liability on the cash gift you are making, consider other savings products such as an ISA (cash or stocks and shares), junior ISA, or potentially even a pension.
"All of these provide a tax-free environment in which your gift can grow and compound, and in the case of a pension, is immediately increased by 20%, 40% or 45%, depending on your loved one’s tax rate.”
