Going Back to Basics – Inheritance Tax Planning

It can often be forgotten in the complex world of tax planning, that sometimes the most efficient and effective forms of tax planning can be the simplest.

This is often the case when considering Inheritance Tax (IHT). In this article, we set out some of the basic, but often overlooked, ways that individuals can reduce the IHT burden on their death estate, and some forward planning can reap big savings.

Overview - Inheritance Tax Planning

A UK Domiciled individual will be subject to UK IHT on two occasions:

• On certain lifetime gifts made during their lifetime; and
• On the persons estate when they die.

IHT on lifetime gifts

These lifetime gifts, fall into three categories:

1. Chargeable Lifetime Transfer (‘CLT’) –where a ‘gift’ or transfer of value is made into a trust or a company, this immediately becomes chargeable to IHT.
2. Exempt Gifts – these are ignored for IHT purposes and do not become chargeable. Examples include gifts to spouses, charities and small gifts made out of ‘normal’ income such as Christmas or birthday presents.
3. Potentially Exempt Transfer (‘PET’) - any gifts which do not fall under the above categories, which only become chargeable if the donor dies within 7 years of the gift. Provided the donor lives 7 years, the gift is ‘exempt’ and taken out of the IHT estate.

IHT on death

UK domiciled individuals are chargeable to UK IHT on death in respect of their worldwide estate, to the extent that their estate does not qualify for any specific exemption or relief.

A ‘taxable’ estate, for UK IHT purposes (before exemptions or reliefs) comprises of three separate components, namely:

How can I reduce my IHT exposure?

So what are your options for minimising IHT exposure? According to HMRC, only 5% of estates pay IHT, likely due to the generous array of reliefs and allowances available. Below we have listed the main beneficial reliefs and allowances you should be aware of:

1. Nil-Rate Band (‘NRB’)

Every individual has a NRB which is taxed at 0% for IHT purposes. For 2021/22, this is £325,000. Therefore, the first £325,000 of value within your estate is taxed at 0%.

If you are married, any unused NRB on the death of the first spouse is transferable to the surviving spouse. Therefore on second death, there is the potential to have a £650,000 NRB. The remainder is taxed at the usual rates.

2. Residential Nil-Rate Band (‘RNRB’)

This is an additional 0% rated amount on any main residence which is passed down to direct lineal descendants, e.g. the family home is passed to a child or grandchild. For 2021/22, this is currently £175,000.

However if your estate is above £2 million, the RNRB is tapered down by £1 for every £2 that the estate exceeds £2 million. For example, lets say your estate is worth £2.25m:

Similarly to the NRB, the RNRB is transferable to your married spouse on first death. But again, this may need to be tapered back if the share of the deceased spouses estate exceeds £2m.

Benefit of Inheritance Tax Planning

Good planning can ensure that the RNRB is maximised. The IHT saving on reducing an estate for a surviving spouse, who can benefit from full transferable nil rate bands, from above the tapering limit for the RNRB to below it gives a significant tax saving:

The effect of gifting £700,000 (assuming they survived 7 years after making the gift) reduced the IHT liability by £420,000, an effective tax saving of 55.5% on the gift.

It should be noted that in calculating the value of the estate on death for the purposes of tapering the RNRB, failed PET’s are not added back to the value, so a saving would still be made to the estate in the final IHT calculation.

3. Charitable donations in Will

A further tax saving can be achieved if 10% of the value on an estate is gifted to charity on death. This reduces the rate of IHT down to 36%, as well as the gift to charity itself being exempt from IHT.

In the above example, had a charity been left 10% of the estate (£200k), the IHT payable would have been reduced further to £1,800,000 @ 36% = £288,000.

4. IHT Exempt Gifts

There are a number of IHT benefits involved in making gifts, including some which do not count as PETS and can immediately reduce your IHT exposure.

Annual Exemption - There is a £3,000 annual exemption for total gifts made to any one person PER tax year. This can be carried forward if unused in the previous year (therefore a potential exemption of £6,000).

Gifts between spouses – These are generally exempt for IHT purposes.

Small gifts – Gifts to individuals not exceeding the value of £250 are exempt
for IHT purposes. E.g. Christmas or
birthday presents.

Wedding gifts – Gifts made in consideration of marriage are exempt up to certain limits. These limits are £5,000 to children, £2,500 to grandchildren and £1,000 to any other person.

Gifts to charities – Gifts to registered charities or eligible political parties are exempt provided they become the property of the charity.

Payments to help with living costs –this does not give rise to IHT. This may include (but not limited to) providing for someone who is an elderly relative or someone under 18.

Gifts out or normal income – when a gift is made out of income and qualifies as ‘normal expenditure’ it is exempt from IHT. ‘Normal’ in this case would mean habitual or typical (i.e. a gift that happens year after year). In addition, the gift will be treated as having been made out of the donors income if the donor is left with sufficient income to maintain their normal standard of living.

Life assurance premiums, payments under deed of covenant or personal pension premiums paid in respect of another person also fall under this exemption.

5. Other Inheritance Tax Planning Opportunities

There are various other opportunities to plan for reducing your IHT exposure, involving the use of trusts, making investments subject to business property relief and agricultural property relief, the use of family investment companies and partnerships (if commercially viable) and many more.

As ever, there are of course certain pitfalls that can unwind any planning which you may need to be wary of and therefore it is always important to take the correct advice before making any gifts.

If you have any queries about this article, Inheritance Tax Planning or tax in general, then please get in touch.