Inheritance tax is often called Britain’s most hated charge, but until recently it was only the very wealthy who had to pay it.
More and more families are now predicted to be caught up in the inheritance tax trap as the value of property has soared – pushing many estates over the threshold.
Data published by HM Revenue & Customs showed it received £7.5bn in inheritance tax in the financial year to the end of March 2024, £400m more than the same period last year.
Official forecasts suggest receipts could top £9.5bn before the end of the decade – but there are ways to cut the inheritance tax bill your estate will face.
In this piece we will cover:
What is inheritance tax?
Upon death, inheritance tax is charged at 40pc on the value of the estate above the tax-free threshold of £325,000 – there is an extra exemption for family homes – which eats into your loved ones’ inheritance.
As a nation we are paying more death duties than ever before. HMRC raked in a record-breaking £6.1bn in 2021-22, doubling in the space of a decade.
Rising property prices and a 20-year freeze on the inheritance tax threshold are pulling more families into the net and causing bills to swell in size. The Government’s decision in the Autumn Statement to freeze tax thresholds until 2027-28 is forecast to cost families £9bn per year by the end of the period.
Rachael Griffin, of wealth management firm Quilter, said: “Inheritance tax has historically been viewed as a tax for the very wealthy, but in recent years we have seen an increase in the number of people being caught in the net.”
Ms Griffin said:“Many people could now find themselves in a position where they end up paying inheritance tax unnecessarily, as they may never have previously considered the need for inheritance tax planning and therefore have not taken the steps required to mitigate it.”
So with more and more estates in danger of the hated tax, here’s how to avoid paying it on your fortune.
How to avoid inheritance tax
As the graph below shows, the very wealthy are able to use clever tricks – with the help of highly-paid accountants – to cut their effective rate of inheritance tax far below the 40pc headline rate. Read on for six ways you too can reduce your bill while staying well within HMRC’s tax rules.
Does writing a will help avoid inheritance tax?
Having a will in itself does not change how much inheritance tax your estate will pay, but it will enable you to decide how your assets are distributed. Without a will, your estate will be dispersed under the “intestacy rules” so it’s vital you have one, especially if you have children or complex finances.
1. Giving assets to your spouse
If you want to cut your inheritance tax bill, then it helps to tie the knot. You can pass on assets of unlimited value to a spouse or civil partner without any inheritance tax liability. According to HMRC, on the first death couples shielded £15.7bn from inheritance tax in 2020-21, the latest year for which data is available.
Since the rules changed in 2007, spouses have also been able to inherit their partner’s unused nil-rate band when they die. This means the surviving spouse could see their allowance grow to £650,000. If the couple owned a home together, the allowance could be as much as £1m, as we explain below.
However the unused allowance is not passed on automatically. You must make a formal claim to HMRC within two years of the death of the surviving spouse – otherwise your family could face an unnecessary tax bill.
2. Leaving your home to your children
For many families a property will be their most valuable asset. In fact, rising property prices are a major reason why annual inheritance tax revenue has doubled over the last ten years.
Fortunately, homeowners get an additional £175,000 allowance – called the “residence nil-rate band” if they pass their main property to family members. And because spouses and civil partners can combine their allowances, they can pass on a total of £1m wealth without incurring a tax bill.
But it pays to be aware of some age restrictions. Ian Dyall, of wealth manager Evelyn Partners, said: “The property must be a residence of the deceased and it must be left to children or grandchildren (not nephews, nieces, brothers or sisters).”
If the person downsized to a less valuable home before their death, they can still use the residence nil rate band. This is called downsizing relief, and it can apply if you sold your more valuable home after 7 July 2015.
Calculating how much downsizing relief you can claim is complicated, however, as this depends on factors like the value of the residence nil rate band and also the home when it was sold.
Ms Griffin said although the residence nil rate band was introduced “to ease pressure on the transfer of the main residence”, the rapid growth of house prices means many who are entitled to it will nonetheless face hefty bills.
For estates worth more than £2m, the residence nil-rate band allowance is reduced at a rate of £1 for every £2 over the threshold. If the residence nil-rate band is not enough to protect your wealth, then you should make the most of gift allowances.
3. Giving away money
Perhaps the simplest way to avoid an inheritance tax bill is to give away your assets during your lifetime.
An often over-looked but highly tax-efficient method is to give money out of surplus income. This must be money you can give away regularly without significantly changing your lifestyle; it cannot be money that comes from a house sale, for example.
Chris Etherington, of tax firm RSM, said: “The gifts don’t need to be of equal size – they just need to be part of a pattern. You should also keep detailed records of the gifts made, in case HMRC asks for evidence of the gifts after death.”
On top of gifts out of surplus income, every individual gets a £3,000 annual exemption. Not many realise this can be carried forward for one tax year – so you could give away £6,000 if your allowance was unused in the previous year.
There are additional allowances for weddings or civil partnerships, although how much you can give varies depending on your relationship to the bride or groom:
Another exemption is the small gift allowance, allowing you to give away up to £250 each year per person – though not to anyone who has already benefited from your £3,000 annual exemption.
All of these gifts are immediately free from inheritance tax – that is to say, they are excluded from your estate. For gifts outside these categories, a seven-year-rule applies.
4. How the seven-year rule works
Large gifts in excess of £3,000 can be made without incurring inheritance tax – but only if you survive the gift by seven years. During this window, the gifts are called “potentially exempt transfers”(PETs). If the value of the estate upon death, plus any PETs, exceed the tax-free allowances then inheritance tax is due.
Gifts made within three years of death are taxed at the full rate of 40 per cent – after that, taper relief will apply at the following rates:
More and more taxpayers are falling foul of the seven-year rule. Families were charged £197m on “potentially exempt transfers” in 2017-18, up from £156m in 2016-17 and £135m in 2015-16, according to figures from HMRC.
This is why it may make sense to give away more money at a younger age. However, Mr Dyall said: “It is obviously important to consider how much you can afford to gift in this way without leaving you or your spouse vulnerable.”
5. Passing on your pension
Regardless of whether you have touched your pension savings, you can pass on the entire pot to your beneficiaries inheritance tax-free.
So even if you had used up your nil-rate band and residence nil-rate band, you could still give away £200,000 in pension wealth, thereby saving £80,000 in inheritance tax.
Just note that the beneficiary will have to pay income tax as they draw down on the pension, but only if the original pension holder dies after age of 75. Mr Dyall said another advantage of incorporating pensions into your estate planning is you can still access these funds if you ever do need to draw on them to pay for care.
6. How a life insurance policy can help
If there is nothing you can do to avoid inheritance tax, you can still insure against the final bill. Taking out a life assurance policy means that when the tax is due, the charge can be paid out of your policy rather than by your beneficiaries.
However, it is important the policy is placed inside a trust to shield it from the estate. Otherwise the payout will increase the estate’s value and potentially the amount of inheritance tax due as a result. Also, these plans can be very expensive. The older you are, the higher the premiums will be.
