Inheritance Tax (IHT) can take a significant chunk out of your estate when you pass away, reducing the amount of wealth you leave behind to your heirs. However, there are several legal ways under UK law to reduce IHT, ensuring that your loved ones benefit from as much of your estate as possible.
Below are some effective strategies for reducing inheritance tax legally within the UK.
Understanding the Inheritance Tax Threshold
In the UK, Inheritance Tax only applies to estates valued above a certain threshold. As of the 2023/2024 tax year, the nil-rate band (the amount that can be passed on tax-free) is set at £325,000 per individual. If your estate is worth more than this, the excess is taxed at 40%.
However, the threshold can increase if you leave your home to direct descendants (children, grandchildren, or stepchildren). This is known as the residence nil-rate band (RNRB), which adds up to an extra £175,000 to the threshold, taking the total to £500,000 per individual (or £1 million for a married couple or civil partners (see below)). I have listed several options below on different ways to reduce inheritance tax.
Spousal and Civil Partner Exemptions
In the UK, transfers of assets between spouses or civil partners are totally exempt from inheritance tax, regardless of the value. This means that when one spouse dies, the surviving spouse can inherit the entire estate without facing IHT.
Additionally, if you have not used your nil-rate band or residence nil-rate band, it can be transferred to your spouse, effectively allowing a married couple to pass on up to £1 million before IHT applies (assuming the full residence nil-rate band is available).
This exemption can be a powerful tool for reducing the inheritance tax burden on your estate.
Utilising the Annual Gift Exemption
One of the most straightforward ways to reduce your estate’s value is to make gifts during your lifetime. The UK allows individuals to give away certain amounts of money or assets each year without it being considered part of the estate for inheritance tax purposes.
You can gift up to £3,000 per year without incurring IHT. This amount can be carried forward to the next tax year, allowing a maximum of £6,000 to be gifted in one year.
Gifts of up to £250 per person to any number of individuals are also exempt from IHT, provided no other exemption is used for the same recipient.
You can gift up to £5,000 to a child, £2,500 to a grandchild, and £1,000 to anyone else without triggering IHT, as long as the gift is made on the occasion of a marriage or civil partnership.
These gifts reduce the overall value of your estate, which can help lower your inheritance tax liability when you pass away.
Make Use of the 7-Year Rule (Potentially Exempt Transfers)
Under UK law, gifts made more than seven years before your death are generally not subject to inheritance tax, regardless of their value. This is known as Potentially Exempt Transfers (PETs).
If you survive for seven years after making the gift, it will not count as part of your estate for inheritance tax purposes. However, if you pass away within seven years of making a gift, it may still be subject to IHT.
The tax treatment depends on when you die. If it’s within three years, the full 40% tax applies. For gifts made between three and seven years before death, there are taper reliefs which gradually reduce the tax rate based on how many years have passed since the gift was made.
Therefore, making significant gifts early can effectively reduce the value of your estate and minimise IHT, provided you survive the seven-year period.
Use of Trusts to Reduce Inheritance Tax
A trust is a legal arrangement where assets are transferred to a trustee, who holds and manages them on behalf of the beneficiaries. Trusts are commonly used to reduce inheritance tax in the UK, especially irrevocable trusts.
In Discretionary Trusts, assets are transferred to a trustee, but the trustee has the discretion to decide how and when the beneficiaries receive the assets. Although this means you lose control of the assets, it can potentially help reduce the value of your estate for IHT purposes.
If you gift assets into a trust, the value of those assets will be removed from your estate. However, to qualify for IHT relief, the gift must be considered a “potentially exempt transfer,” and the seven-year rule applies.
Bare Trusts is another type of trust an individual can use, it allows the beneficiary to access the assets at any time, and upon reaching a certain age. This can be particularly useful for parents who want to pass on assets to their children, with minimal tax implications.
Trusts can be complex, so it is vital to seek professional advice when considering them, but they are an excellent way of managing inheritance tax and ensuring wealth is passed down in a controlled manner.
Make Charitable Donations
Charitable donations can significantly reduce your inheritance tax bill. Under UK law, if you leave 10% or more of your estate to charity, your IHT rate can be reduced from 40% to 36%.
Charitable donations are exempt from inheritance tax, meaning that any assets you leave to charity are not counted towards your taxable estate. If you have charitable inclinations, this can be a good way to reduce the overall tax burden while supporting causes you care about.
Life Insurance
Taking out a life insurance policy in a tax-efficient manner can help provide liquidity for your estate, which can be used to pay any inheritance tax due. If the policy is placed into a trust, it will not form part of your estate for IHT purposes, thus reducing the amount subject to tax.
Conclusion
In the UK, there are numerous legal strategies available to reduce or even avoid paying unnecessary inheritance tax and ensure that more of your wealth is passed on to your heirs rather than going to the government.
However, these strategies can be complex, and it’s always advisable to consult with a solicitor or financial advisor to ensure you're making the most of the available opportunities to reduce your inheritance tax liability legally.
Megan Clark
The information provided in this article is not intended to constitute professional advice and you should take full and comprehensive legal, accountancy or financial advice as appropriate on your individual circumstances by a fully qualified Solicitor, Accountant or Financial Advisor/Mortgage Broker before you embark on any course of action.
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