In this article we explain to whom Inheritance Tax is likely to apply and outline strategies that can be used to mitigate the tax. It should be useful for anyone who is concerned that their estate may be subject to the 40% inheritance tax.

This article is a generalised guide only and it does not constitute tax, legal nor financial advice that is personal to any individual’s unique circumstances. We believe the information contained in this article to be accurate as of 11 May 2021 although we cannot guarantee this. Before taking any action concerning potential inheritance tax mitigation, we strongly advise you take regulated financial advice.

When does Inheritance Tax apply?

In the simplest terms, any estate worth more than £1 million will incur inheritance tax of 40% (unless exemptions apply). The 40% tax is paid on the value of the estate that is above the threshold amount (e.g. £1 million).

The 40% inheritance tax technically begins once an individual’s estate is worth more than £325,000. If you’re married or in a civil partnership, you can combine this allowance with that of your spouse such that your combined threshold amount becomes £650,000. If you own your own home and leave it to a family member, you have a residence exemption of £175,000 which doubles to £350,000 if it is combined with your spouse’s exemption. Therefore, a married couple will be subject to inheritance tax if their estate is worth more than £1 million – unless mitigating steps are taken.

One final wrinkle: if your estate is worth more than £2 million then the residence exemption declines gradually such that an estate worth £2.7 million receives no residence exemption – and therefore pays 40% inheritance tax on the value above £325,000 (or £650,000 for a couple).

How can you mitigate your Inheritance Tax liability?

First of all, it’s important to understand that inheritance tax planning should be done as part of a wider plan for your finances. There are various ideas outlined below but none would be appropriate if it were not in your best interests, including your ability to fund yourself for the rest of your life and to pay, potentially, for costly care in old age. Therefore, you should consider the ideas below as possible options that could form part of a plan that focuses on you first and then considers how to mitigate your estate’s inheritance tax liability.

Ensure you have a suitable will

An up-to-date will is fundamental to inheritance tax planning. There is the obvious reason that a will ensures your assets are passed on to your intended beneficiaries. But there are also more nuanced reasons to ensure you have an appropriate will including that the residence exemption outlined above only applies if your home is left directly to your descendant(s). Many older wills hold assets in trust which would likely mean losing out on this valuable exemption.

Gifts whilst you are still alive

Giving away your money or assets is perhaps the most straightforward way of reducing your inheritance tax liability: all gifts are exempt from inheritance tax provided that you survive at least seven years from the time at which you give the gift.

It is possible to give these gifts into certain structures that are tax efficient for the recipient and/or set some limits on the beneficiaries ability to access the gift immediately. For example, contributing to a child or grandchild’s pension can be a tax efficient way of passing on your wealth without simply giving them a lump of cash. Contributions to Lifetime ISAs and Junior ISAs offer similar opportunities.

In sum, gifting while you are still alive can, potentially, reduce a 40% inheritance tax burden to zero whilst also supporting your beneficiaries’ long-term, tax-efficient savings and investing.

Gifts from income

Provided a gift is made as part of a regular pattern of giving and is funded from actual income (and not, for example, by selling assets), the gift can be free of inheritance tax. This can be a very useful exemption but it requires clear evidence that the gifting was regular and came from income otherwise HMRC may demand that inheritance tax be paid by those to whom you have made the gift (if you pass away within seven years of the gift being made).

Charitable giving

All gifts to charity are free of inheritance tax. Furthermore, if at least 10% of your estate is left to charity then the rate of inheritance tax applied to the portion of your estate that is liable for inheritance tax is reduced from 40% to 36%.

Make use of pensions

Pensions are (usually) exempt from inheritance tax. For this reason pensions are often an exceptionally good way to both protect your future standard of living and to ensure that your beneficiaries are protected from the 40% inheritance tax. In other words, you can draw on your pension if you need it later in your life but if it turns out that you don’t need the funds within your pension then there is no inheritance tax levied on them. Contrary to perceived wisdom, it is therefore often advisable not to draw on your pension in retirement – at least not until you need to.

The use of trusts

There are various trusts available although the rules surrounding trusts are complicated. One popular trust structure is a ‘discounted gift trust’ which is a trust that both pays you an ongoing income while protecting the assets within the trust from inheritance tax. Importantly this allows you to retain an income from the assets.

Trusts can also be used to protect your children, grandchildren and/or other beneficiaries from potential marital disputes. Similarly, trusts are sometimes used to delay giving money to beneficiaries until they are at a more appropriate age to receive the funds. In short, there is a large amount of flexibility and protection that trusts can provide and such benefits can be appealing in addition to any inheritance tax benefit.

Life insurance

Life insurance is often used to negate an immediate inheritance tax liability. For example, if you own a holiday home and you were to pass away then your estate may have to pay 40% of the value of that home to HMRC. A life insurance policy – that is, crucially, written in trust – could be used to pay that tax liability thus allowing your beneficiaries to keep ownership of the holiday home.

Sensible, long-term inheritance tax planning often involves purchasing life insurance for someone who is at a relatively young age and then reducing that life insurance cover over time as other actions are gradually taken that reduce the inheritance tax liability.

Business Property Relief and EIS Investing

Shares in certain businesses are free from inheritance tax. A number of companies that are listed on the AIM stock market (which is essentially London’s ‘junior’ stock market) are not subject to inheritance tax. Similarly, investments in small private companies that qualify for the government’s ‘Enterprise Investment Scheme’ (EIS) are also free from inheritance tax.

Such investments, however, are risky and they are therefore not appropriate for everyone. Nevertheless, they can form an important part of a tax-efficient portfolio.

Why now?!

You could be forgiven for preferring to not think about inheritance tax – it is an unpleasant subject for many reasons!

However, ideal inheritance tax planning can rarely be implemented at the snap of your fingers. For one, there is a limit on how much one can contribute tax-free into a trust (£325,000 per person) and that limit resets every 7 years. This makes multi-decade planning much more effective than trying to tackle these issues very late in life. Similarly, some of the tax benefits outlined above must be used in the current tax year or they are lost – which means that the best strategy often involves ongoing or annual contributions (like contributing to a child’s pension once per year).

If you are serious about wanting to mitigate your inheritance tax liability and are fortunate enough to have a relatively high net worth then making a plan as soon as possible is likely a very good idea.

How we can help

We are experts in Inheritance Tax planning strategies including pensions, trusts and other relevant structures. As part our twin approach – which encompasses financial planning and investment management – we help clients with a plan that incorporates their own financial objectives for later life and, subsequently, their desires for passing on their wealth.