Although it may seem morbid to think about your own death, having a financial plan in place for after you die is almost as important as having a financial plan when you’re alive.
Inheritance tax (IHT) is one of the most hated taxes because it taxes your loved ones for possessions and investments that you have already paid tax on. In this Blog and next weeks, I’ll discuss some of the steps you can take now to mitigate it in the future.
What is IHT and will it affect me?
IHT is levied on your wealth, or estate, after you die. The tax is 40% on estates over the threshold of £325,000, known as the ‘nil rate band’. Your estate includes any property, possession, money, savings and investments you may have. Assets held in trust and even gifts you made when alive could all be liable for IHT.
Many people think IHT is only paid by the super-rich, but thanks to a decade of unprecedented house price rises even those with modest homes – especially in London and the South East – could see themselves fall into the IHT trap.
Unfortunately the IHT threshold has been frozen until 2014/15 although some argue that if the threshold had risen in line with inflation, each person would be entitled to a £500,000 nil rate band.
Some estates are completely exempt from paying IHT. Exempt estates include:
- Those valued at under £325,000
- Those where the deceased left everything to a spouse or a qualifying charity and the estate worth is under £1 million.
- Those owned by someone domiciled in a foreign country who died abroad and has a UK estate valued at less than £150,000.
If your estate qualifies as exempt you will need to fill in HMRC’s IHT205 Return of Estate Information form (known as C5 in Scotland).
How can I avoid IHT?
IHT is an unpopular tax but there are ways to arrange your financial affairs to minimise your bill, or even escape IHT altogether.
The impact of IHT is reduced by a number of exemptions and reliefs. It is important to understand the distinction between exemptions and reliefs.
- An exemption means that the transfer does not count as a chargeable transfer and is therefore neither taxed nor included in the cumulation for the future.
- A relief reduces the value of a chargeable transfer. It does not remove the transfer from the tax regime but merely reduces its value.
Can’t I just give my money away before I die?
A simple way to reduce your wealth for IHT purposes is to give your money away when you are alive. However, there are limits on how much money you can give away.
Gifting your money away falls into two categories: tax-free gifts and potentially exempt transfers (PETs).
Tax-free gifts include:
- Annual Exemption – you can give away gifts worth £3,000 each year and can also carry forward any unused allowance but only from the immediately previous year, ie. if you didn’t make any gifts in the previous year then you can gift £6,000.
Warning – if you don’t use it, you lose it.
- Those between spouses or civil partners who are both domiciled in the UK. If one party is domiciled abroad, the gift is capped at £55,000.
- Those to national institutions, museums, universities, the National Trust, small political parties, housing associations and amateur sports clubs.
- Those to people getting married. If you are a parent of the couple marrying you can gift £5,000, £2,500 if you are a grandparent or other relative, £2,500 each between bride and groom or civil partners. Anyone else can give £1,000.
- Those made out of ‘normal expenditure’. If you can prove the money you are giving away is out of surplus income then it becomes tax-free. To qualify the gift must not reduce your standard of living and is not from capital. It must also constitute a regular spend so if you want to give away a little each month it is best to set up a standing order from your current account.
- Small Gifts – gifts of up to £250 at any one time for birthdays, Christmas presents etc.
- Gifts for maintenance of spouse, ex-spouse, civil partner or ex-civil partner. The gifts are also exempt if made to relatives who are dependent on you because they are elderly, infirm, children in full-time education.
Potentially Exempt Transfers (PETs):
PETs are gifts that do not immediately fall into the tax-free gifts category but could become tax free in future. A PET becomes an exempt transfer if the donor lives for seven years after gifting the money to the individual , organisation, bare trust or disabled trust.
However, if the donor dies within seven years the PET becomes a chargeable transfer and the person who received the PET will be asked to pay 40% IHT on it. The amount of tax is calculated using taper relief, meaning the older the gift, the larger the reduction in tax.
If the gift was made less than three years before death there is no reduction in the tax charge. For gifts made three to four years before death tax is reduced 20%; 40% for gifts made four to five years before death; 60% if made five to six years before and 80% if made six to seven years before.
If the PET that has become chargeable is fully within the nil rate tax band the tax will be nil but the donor’s IHT allowance will be reduced accordingly. For example a gift of £50,000 where the donor died within seven years would utilise £50,000 of the donor’s IHT allowance and so reducing the remaining allowance to £275,000.
Top tip: It is worth noting that if you wish to give 10% or more of your estate to charity the rate of IHT for your whole estate (above the nil rate band) is reduced from 40% to 36%.
Next week we’ll conclude by covering other gifts, reliefs, nil-rate bands & actual payments.