Tips to minimise the tax toll on your earnings
Daniel Defoe wrote there is nothing “as certain as death and taxes” and doubtless he, like many others, would have been shocked by the insensitivity of a tax that is timed to coincide with life’s other certainty and for many seen as a tax on tax.
As Baby Boomer wealth, fuelled by ever-rising house prices continues to increase, more and more families are likely to be impacted by Inheritance Tax (IHT).
However, if you are one of those fortunate enough to believe you will have an Inheritance Tax liability on your estate, paying Inheritance Tax doesn’t have to be inevitable. One option of course is to spend more to reduce your liability, but for those who want to see their wealth support their family or charitable causes, this most emotive and unpopular of taxes can typically be minimised or mitigated altogether through the use of allowances or exemptions with careful and timely planning.
A tax on the combined value of all your property, possessions, investments, savings, cash and any other types of assets that fall within your estate, IHT is payable when those assets are transferred to members of your family or other beneficiaries on death, other than your husband, wife or civil partner. The standard threshold or Nil Rate Band for IHT, currently fixed until 2028, is £325,000, beyond which your estate will typically pay 40% IHT. This reduces to 36% if you give away at least 10% of your ‘net’ estate to charity.
The new Residence Nil Rate Band
A recent but complicated addition to the Nil Rate Band allowance is the introduction of the ‘Additional Threshold’, more commonly known as the Residence Nil Rate Band (RNRB) that applies if you pass on your family home (not a second home or buy-to-let property) to direct descendants. The RNRB was increased to £175,000 in April 2020 and again is currently fixed until 2028. The complication comes from two main areas: a cap of £2m of total assets, excluding pensions, after which the allowance is tapered down by £1 for every £2 over the cap; and the definition of direct descendants. Some trusts work for this purpose and others do not, so it is worth reviewing your will, especially if it involves a trust and was written over two years ago, to ensure that you are making the most of these allowances.
Both the Nil Rate Band and the Residence Nil Rate Band can be transferred between married couples and civil partners when one person dies and this also applies to previous marriages or civil partnerships, although as this adds complexity it would be advisable to seek financial advice in this instance.
Gifts to family members or friends
Gifting is a relatively straightforward way to reduce IHT, but various gifts do have different Inheritance Tax treatments depending on the value of the gift, the timing and who the beneficiary is. Some gifts are free from IHT, notably gifts to your wife, husband or civil partner and gifts up to the value of your annual gifting allowance of £3,000. It is important to be aware that this does not mean £3,000 per person but in total and can be carried forward to the next year – but only for one year.
There are other allowances that can be used each tax year, such as wedding or civil ceremony gifts up to £1,000, rising to £2,500 for a grandchild or great-grandchild and £5,000 for your children when they get married or go into a civil partnership.
Other options include normal gifts out of income, provided you can demonstrate it will not impact your normal lifestyle. Payments to help with another’s living costs, such as an elderly relative or child under 18, and gifts to charities or political parties, are other exempted gifts for Inheritance Tax purposes.
Larger gifts and making gifts in trust
Whilst the above exempted and small gifts are useful, making a proper dent into your Inheritance Tax liability is likely to involve gifting larger sums either directly or into trust. There are two types of trusts that are most commonly used: bare or discretionary.
Although the variations on these can leave people confused, trusts can be very useful to give the settlor (the person setting up the trust) control over how the assets are distributed long after they are gone. They also provide protection for family wealth by keeping it safe and in the hands of the people that matter most to you.
Gifting directly is the simplest and cleanest route to mitigating your Inheritance Tax liability and gives you the delight of seeing those that benefit putting the money to good use, be it grandchildren’s school fees or helping your child onto the property ladder.
The seven-year rule
However, one aspect of making larger gifts that needs to be considered is the seven year ‘rule’, whereby gifts generally fall outside of your estate for Inheritance Tax purposes seven years from when they were gifted. If you die within seven years of making a potentially exempt gift it will form part of your estate for IHT purposes. However, if the gift was made more than 3 years ago taper relief may reduce the rate of IHT that is paid on the gift.
Claiming Business Relief
Another option is to take advantage of Business Relief which reduces the value of business property for Inheritance Tax. It's available on the transfer of assets including land, buildings and machinery owned by the business, as well as on unquoted shares such as those listed on the Alternative Investment Market (AIM).
To qualify the business asset must usually have been owned throughout the two years prior to death or transfer.
Protecting the liability
Possibly the simplest option is to take out a life insurance policy that pays a lump sum into a trust for your beneficiaries, as the money will remain outside your estate and can be used to settle the IHT bill without the need to wait for a Grant of Probate.
The rules around IHT are amongst the most complex in our tax system and frequently updated, so if you think you may have an IHT liability seeking financial advice is important. Whether your motivation is to support your relatives, protect vulnerable family members or simply to ensure the tax man isn’t your largest beneficiary, the earlier you start the conversation, the more effective Inheritance Tax planning is likely to be.
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Tax treatment is dependent on individual circumstances. This information is provided in good faith and is based upon our understanding of current tax law and HMRC practice, which may be subject to change in the future.
This article does not offer advice and the content and information about potential investments and services are designed for general use, and so cannot be considered personal to your circumstances or your financial position. It is important to obtain professional advice from an accountant or tax specialist before taking any action or making any decisions.
AIM company shares tend to carry higher risk than those listed on the main market of the London Stock Exchange. The tax relief available on AIM shares is subject to certain criteria which may be subject to change in the future. There is no guarantee that companies will qualify, or continue to qualify, for tax relief.
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