The amount of inheritance tax (IHT) collected by the government’s coffers has soared over recent years to a record £5.4bn in the 2018-19 tax year.
Rising property prices and a stagnant tax threshold are partly behind the increase. Yet it could also be down to families who are failing to take advantage of the range of gift allowances and exemptions that are available to them to minimise their liability to IHT.
However, there are pitfalls to beware when making use of various allowances, stresses Justin Modray, director at Candid Financial Advice. “Unless you have more money than you could possibly spend during your lifetime, then inheritance tax planning is akin to walking a tightrope,” he says.
“Give away too much during your lifetime and you might compromise your quality of life; give away too little and the taxman might get his claws into your estate on death.”
You are entitled to pass on assets worth up to £325,000 free from IHT on death, and transfer any unused IHT allowance to your spouse or civil partner. This may be boosted by the residence nil-rate band, introduced in April 2017, which applies when passing on a property to direct descendants.
“If you gift your home to your children and your estate is below £2m then your nil-rate band increases to £475,000, rising to £500,000 from April 2020,” says Mr Modray.
Any excess over the IHT nil-rate band is taxed at 40 per cent. This could amount to a significant bill, particularly if you have substantial assets built up over your lifetime.
Giving away income and assets
You will, ideally, have made a will to ensure your estate goes to who you want and that your wishes are carried out after your death. This may need occasional amending as your circumstances and the rules around IHT evolve over time.
Remember that your existing will is automatically revoked if you get married, in part if you get divorced, and you will probably want to make amendments if you have children.
However, you are able to transfer assets tax efficiently to your family during your lifetime in addition to, or instead of, after your death. Money gifted in this way could, for example, give children a leg-up onto the property ladder, pay off debt, or kick-start their pension.
Gifting money and assets during your lifetime also enables you to retain control over who inherits what, particularly where there are complicated family structures that could potentially cause disputes after your death.
“The typical family these days in not necessarily that straightforward any more,” says Svenja Keller, head of wealth planning at Killik & Co.
“Complex family webs with children from different marriages combined with lack of communication between the generations could mean that the provisions of a will may come as a surprise to some family members.
“This could lead to potential emotional upset or even disputes that the donor can no longer address. Lifetime gifting would at least still provide the opportunity to explain the reasons to the family members involved.”
She adds that clients often make lifetime gifts to see how children and grandchildren benefit from the money while they are still around. “This is a fairly common reason for making these gifts, particularly when it’s spent on education and helping children onto the property ladder,” she says.
You can gift up to £3,000 a year as an exempt (from IHT) gift, or £6,000 if you did not make a gift of this nature in the previous tax year. So a married couple can hand over a total of £12,000 to their children, for example, in a single year, which will reduce to £6,000 each year thereafter.
Sarah Coles, personal finance analyst at Hargreaves Lansdown, says: “We see plenty of parents and grandparents using their annual allowance to help children on to the property ladder. The £3,000 goes a long way to using the full £4,000 Lifetime Isa allowance, which means they benefit from the 25 per cent government top-up on your gift too.”
You can also give £250 away as part of your gift allowance to any number of people each year. However, you are unable to combine this with your £3,000 annual IHT exemption. Parents can also give up to £5,000 to their children as a wedding gift under the annual exemption rules, while a grandparent can give up to £2,500 and any other friend or relative can give up to £1,000.
Potential pitfalls of lifetime gifts
You run the risk of creating hefty capital gains tax (CGT) bills without careful planning if you are gifting assets such as shares or funds to anyone other than a spouse. That is if the asset is carrying a gain that uses up more than your annual allowance, amounting to £12,000 in the 2019-20 tax year.
Ms Coles suggests staggering gifts of this kind of asset to ensure you don’t go over your CGT allowance in any given year. Alternatively, you could focus on gifting from cash accounts, adds Ms Keller.
You also need to be completely clear you’re giving something away when making any gift to minimise IHT. Mr Modray says: “When you give money or assets away, it must be without ‘reservation’, that is you can’t continue to enjoy a benefit from them.”
For example, if you gift your home to your children but continue to live there, you will have to pay them a market rent or the gift will be void for IHT purposes.
To clarify any gifts that have been made, keep an up-to-date list of any assets you hold alongside details of the gifts you have made over the past 14 years, and the dates you made them, says Ms Coles.
By contrast, gifts to charities are free from IHT and CGT. “And if you leave 10 per cent of your net estate to charity through your will your IHT rate reduces to 36 per cent so it almost pays for itself,” adds Ms Keller.
Beware that once you have gifted money or assets you can also no longer use them if, for example, you live for longer than expected and face hefty long-term care bills. You should, therefore, avoid giving assets or money away that you may need in the future.
“You need to put your own life vest on first before making gifts to family, and consider your own expenditure and potential long-term care costs,” says Ms Keller.
Instead of giving a lump sum you could make regular gifts out of your income. Provided this does not affect your standard of living, any amount can be given away and ignored for IHT.
By giving from your income over the years, you avoid whittling away your savings, provided you leave sufficient amounts for your standard of living. Patrick Connolly at Chase de Vere says: “For those with larger incomes this can make a significant difference to their potential IHT liability.”
Annual gift allowances and giving out of income can help reduce your IHT liability. However, they may not make an enormous difference if you have assets that are worth significantly more than the tax nil-rate band of £325,000.
A solution in this scenario is to make use of so-called potentially exempt transfers (PETs). However, you need to survive for seven years after making the gift for it to be considered outside your estate for IHT purposes.
Mr Connolly says: “If you die within seven years of making a PET and the total of the PETs you make is less than £325,000, then the value gifted will simply reduce your nil-rate band on your death. So while this means that those receiving the gifts won’t be liable to tax, it also means that you won’t make any IHT savings by making these gifts.”
However, tax is liable on a sliding scale three years after making the gift if the value amounts to more than the £325,000 nil-rate band.
A life insurance policy could be taken out to either meet or reduce a potential IHT bill – for example, to provide a cash payment if you do not survive for seven years after making a large gift. “This is a fairly common thing to do if you are making significant gifts,” says Ms Keller.
Making use of trusts
Another option is to make lifetime gifts but maintain control over how your assets are used by future generations by ring-fencing them in a trust. “You can drip-feed money into the trust each month, which may count as regular gifts from income,” says Ms Coles. “Alternatively, you can pay a lump sum into the trust.”
You’re essentially handing over cash to the trustees, but the beneficiaries cannot take control of money held in a trust except under particular conditions. “The assets you put in to trust no longer belong to you, so in the event of divorce, bankruptcy or unsettled debts on death, you’ll have peace of mind knowing that the trust will still go to the intended recipient,” adds Ms Coles.
However, rules around using trusts can be complex and you will likely need legal or professional financial advice.
“Using a trust can incur high tax charges and may be irrevocable, so it’s important to tread carefully and fully understand what you’re doing,” says Mr Modray.
A basic type is a bare trust, he adds, which may suit if you simply want to stop a child accessing money until they are 18 years old. “The money is treated as the child’s for tax purposes, so is likely to be tax efficient, although once set up it cannot be changed,” he adds.
Another type of trust used to mitigate IHT is a discretionary trust, which is potentially more flexible in allowing you to change the beneficiaries and terms of the trust. But Mr Modray stresses: “Beware that taxes on income and capital gains on assets within are steep, and if total gifts into this type of trust exceed your nil-rate band the excess will be classed as a chargeable lifetime transfer and taxed at 20 per cent, with a further period charge of 6 per cent every 10 years.”
Life policies may benefit from being placed in trust so any payout is made outside your estate and can be put towards your tax bill. “However, if the policy is written into trust, the premiums will be classed as gifts which can make matters complicated – although these may fall within the gifts out of income or annual exemption rules,” adds Ms Keller.
With all the different allowances and exemptions, IHT planning can substantially reduce or even wipe out a potential tax liability. However, the rules can be complicated and some leave it too late to minimise their liability. It may be worth seeking legal and professional financial advice to ensure you make the right decisions for you, and if you are unsure of the available options.
