Inheritance Tax (IHT) is a tax on the estate of someone who has died. This includes their money, property, and possessions. The standard Inheritance Tax rate is 40% on anything above the threshold, which is currently £325,000 for individuals and £650,000 for married couples and civil partners. This means any estate valued over the threshold could be liable for a significant IHT bill upon the death of its owner. However, there are numerous ways the wealthy can reduce or even eliminate their IHT liabilities through careful financial planning and use of reliefs and exemptions.
Ways to Avoid Inheritance Tax
Here are some of the main methods rich people commonly use to pass on more wealth to their heirs and reduce Inheritance Tax liabilities:
Lifetime Gifts
Gifts made more than 7 years before the death of the person making the gift are generally exempt from Inheritance Tax. So making gifts early and systematically can be a very effective way to pass on wealth without incurring IHT. The 7 year rule does not apply to gifts into certain trusts. With careful planning, substantial sums can be gifted over a lifetime without incurring IHT. The gifting rules are complex, so professional advice is advisable.
Annual Exemption
Everyone has an annual gift exemption of £3,000. Unused exemption can be carried forward one tax year. So in total £6,000 can be gifted tax-free each year. Married couples and civil partners can therefore gift £12,000 between them annually IHT-free.
Small Gifts Exemption
In addition to the annual exemption, small gifts of up to £250 per recipient per tax year are exempt from IHT. This exemption is intended for regular birthday and Christmas gifts. There is no limit to the number of small gifts allowed.
Normal Expenditure Exemption
Gifts made out of surplus income, rather than capital, are exempt from IHT provided they do not reduce the standard of living of the person making the gift. This exemption commonly allows wealthy individuals to gift substantial regular sums to family members.
Marriage Gifts
Wedding gifts are exempt from IHT up to the following limits:
- £5,000 from a parent of the marrying couple
- £2,500 from a grandparent or more distant relative
- £1,000 from anyone else
If the marriage doesn’t go ahead, the exemptions may have to be repaid.
Charitable Gifts
Gifts to qualifying charities and political parties are exempt from IHT. Leaving at least 10% of an estate to charity can also reduce the IHT rate from 40% to 36% on some assets.
Agricultural and Business Property Relief
Assets such as farmland and some business assets can receive up to 100% IHT relief if held for the requisite number of years. Owning such assets and holding them long term can eliminate an IHT charge on their value.
Pensions
Pension funds including defined contribution pensions are normally exempt from IHT provided they are not used to provide benefits already in payment. Defined benefit pensions in payment may be exempt depending on the type and timing of benefits.
Trusts
Assets can be put into trust, thereby no longer forming part of the estate of the person who created the trust. There are complex rules around trusts but they can be an effective way to pass on wealth without incurring immediate IHT charges.
Life Insurance
Taking out a suitable life insurance policy written into an appropriate trust can provide funds to pay any IHT bill upon death without the need to sell assets from the estate.
Main Residence Nil-Rate Band
In addition to the standard IHT nil-rate band of £325,000, there is an additional nil-rate band of £175,000 when passing on a home to direct descendants. This is the Residence Nil-Rate Band (RNRB). It works on top of the standard nil-rate band and is transferable between spouses. So for a married couple, the combined RNRB is currently £350,000.
The RNRB is reduced by £1 for every £2 that the net value of the home is over £2 million. It only applies to a main residence and cannot cover more than one home. The residence must be inherited by direct descendants (children, grandchildren etc) to qualify.
Reduced Tax Rates for Some Assets
While the main IHT rate is 40%, some assets attract lower rates if certain conditions are met:
- 36% rate – on death estates where 10% or more of the net value is left to charity
- 28% rate – on assets held in trust on death of person with interest in possession trust
- 20% rate – on assets held in trust upon the death of a bereaved minor
Example IHT Planning Using Reliefs and Exemptions
Here is an example to show how the various exemptions and reliefs can be used by wealthy couples for effective IHT planning:
John and Jane’s IHT Planning
John and Jane are married and have a combined estate of £5 million. This includes their main residence valued at £2.5 million, holiday home at £500,000, cash and investments of £1.5 million, art collection worth £300,000 and Jane’s business valued at £200,000.
Without any IHT planning, their estate would attract IHT of 40% on the value above £650,000, meaning a potential IHT bill of over £1.5 million.
However, by using available exemptions and reliefs, they could legally minimize this as follows:
- Leave holiday home to their children – covered by RNRB of £350,000
- Gift art collection to children at least 7 years before death – covered by lifetime gifting rules
- Jane’s business qualifies for 100% business property relief
- Take maximum advantage of annual gifting allowances
- Make regular lifetime gifts out of surplus income
- Put £1 million into trusts over several years
- Leave 10% of remaining estate to charity to reduce tax rate to 36% on balance
Result: By using all available IHT reliefs optimally they could potentially reduce their IHT liability from over £1.5 million to less than £200,000 – massive savings for their heirs.
This example shows how, with careful planning, even those with very large estates can minimize IHT liabilities.
Conclusion
Inheritance Tax planning is crucial for wealthy individuals who wish to pass on as much as their estate to heirs as possible. While IHT is hard to avoid completely, there are many legitimate exemptions and reliefs which can be used to significantly reduce IHT liabilities. The rules are complex, so taking professional legal and financial advice is essential. But with meticulous planning, it is possible for even those with large estates to minimize the amount of their wealth lost in inheritance taxes.
