Inheritance tax bills are set to rise – will you be caught out?

The number of people who actually pay inheritance tax is very small. But more and more estates are set to be dragged into its net, says David Prosser. And that could include you.

Inheritance tax
(Image credit: © Getty Images/iStockphoto)

In earlier articles, we’ve discussed how to calculate the value of your estate, including the value of your property. You may now have a better idea of what your estate is worth and whether you are likely to face an inheritance tax (inheritance tax) bill or not.

Either way, the good news is that there are all sorts of straightforward and perfectly legal ways to plan ahead in order to minimise an inheritance tax bill, or to wipe it out altogether.

What can you give away now?

The simplest of these is to start giving away assets in order to reduce the size of your estate. For inheritance tax purposes, such gifts effectively fall into two categories: those that are tax-free straight away, and those that only officially drop out of your estate after a period of time, typically seven years.

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The first category gives you plenty of headroom. Each year, you can make as many gifts worth £250 or less as you want. You can also make larger gifts, up to a total of £3,000 in any one tax year; any of this allowance not used can be carried forward into the following tax year.

All donations to charities and political parties also count as tax-free gifts. In addition, parents can give children getting married gifts worth up to £5,000 without affecting their other allowances; grandparents and others get smaller allowances of this type, worth £2,500 and £1,000 respectively.

Another option here is to give away your surplus income. If you can show you have more money coming in than you need to sustain your lifestyle, and you are prepared to commit to regular gifts as part of your normal spending, you can pass on as much of this surplus as you like with no inheritance tax implications.

The seven-year rule

Gifts that do not fall within any of these allowances and exemptions are known as “potentially exempt transfers” (PETs). They will still fall out of your estate for inheritance tax purposes, but only if you live for at least seven years after making them.

If you die sooner than that, the value of PETs still outstanding will be added back on to your estate according to a tapered scale. Gifts made less than three years previously are counted in full; those made between three and four years ago are discounted by 20%; rising to 40% for gifts made four to five years ago; and so on over each two-year period until you get to 100% after seven years.

Keep careful records

If you are in any doubt about how gifts might affect the inheritance tax position of your heirs, you should take professional advice, particularly as the small print can get quite technical.

Even if you do not get such help, make sure to keep meticulous records of the gifts you have made. These will ensure that whoever is responsible for sorting out your affairs after your death is able to do so easily – and that your heirs get the full benefit of your planning.

One important issue to watch out for is that if you continue to enjoy a benefit from an asset you have gifted, the gift will not count for inheritance tax purposes. One obvious example is your home. If you give it away in order to get its value out of your estate but continue to live in it without paying rent to the new owner, the property will still be counted as part of your estate.

Be careful with trusts

Also take care with trusts. One popular inheritance tax planning strategy is to gift your assets into a trust; these assets are then owned and controlled by your nominated trustees who have a legal opportunity to manage the assets on behalf of your chosen beneficiaries.

However, while assets in trust do not count for inheritance tax purposes after your death, you may have to pay a 20% charge when you first make the gift – and further levies of 6% every ten years thereafter. Always take professional legal advice on trust structures.

Finally, even if you can’t beat an inheritance tax bill in full, you can insure against it, with a life insurance policy that pays out to the value of the expected bill for your heirs. Providing the policy is written into trust – insurers can usually help with this – there will be no inheritance tax to pay on this money.

The premiums paid to the insurance policy count as a gift if you pay them yourself, but these can usually be covered by one of your tax-free exemptions. Just be aware that life insurance can be expensive if you are older or in poor health.

This is the third in our series on inheritance tax. For the full report and more, subscribe to MoneyWeek magazine and get your first six issues free – sign up here today.

David Prosser
Business Columnist

David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.