Increasing numbers of people are paying inheritance tax (IHT), but there are ways to reduce your estate’s bill before you pass away.
While IHT has long been seen as a tax on the super-rich, said MoneyWeek, “more and more people are being dragged over the threshold and being forced to pay the unpopular levy”.
The number of inheritance tax receipts is at its highest level in 20 years, according to HMRC data, with 41,000 people liable to pay the tax in 2022/2023 – an increase of 24% from the year before.
Inheritance tax may be associated with people “leaving behind country mansions and grand estates”, said The Money Edit, but with rocketing house prices and a freeze on tax breaks, “more families will be left facing an inheritance tax bill when a loved one dies”.
Who pays inheritance tax?
IHT may be Britain’s most hated tax, said The Times Money Mentor, yet fewer than 5% of estates actually pay it.
IHT is levied against the estate of someone who has died. Taxable assets include your home, car, savings and possessions, explained The Money Edit. Unlike with income tax, there’s no “sliding scale”, the financial website explained, as IHT is charged at a “whopping 40% on everything you leave above a certain limit”.
Savings offers from our financial partners
- İşbank, 4.75% AER on up to £85,000, fixed for one year. No withdrawals allowed during fixed term. Interest paid after 12 months
- Starling Bank, 3.25% AER on £2,000 to £1m, fixed for one year. No withdrawals allowed during fixed term. Interest paid after 12 months
- Brown Shipley, 3.5% AER on £1,000 to £85,000, easy access. Withdrawals and deposits allowed (minimum transaction £500 and balance must remain between £1,000 and £85,000)
- First Direct, 7% on up to £300 per month, fixed for one year, paid after one year. Making a withdrawal will result in less interest being paid. Must also open a First Direct current account (new customers qualify for £175 switching bonus).
Interest rates retrieved on 17 May 2023. When you apply via links on our site, we may earn an affiliate commission
The politics of IHT are controversial, said MoneySavingExpert. The argument for the tax is that it “redistributes” inherited wealth, so instead of it only benefitting the children of the rich, “some of the money goes to the state to be distributed for the benefit of all”.
The argument against it is that when money is earned, tax is paid at the time, “so to pay tax on it again isn’t fair.”
There are ways to reduce your IHT bill and pass more money on to your loved ones without giving it to the taxman.
Inheritance tax allowances
Everyone has an inheritance tax allowance of £325,000. This is known as the nil-rate band.
While this might seem like a generous amount, said The Money Edit, “the rate at which property prices are rising means far more people would now be subject to the tax”, especially if they have other investments and assets as well as property.
There is also an extra allowance if you leave your home to your children or grandchildren. This is called the residence nil-rate band, and it is currently set at £175,000.
Husbands, wives and civil partners can also leave assets to one another tax-free, regardless of the amount. Making the most of this in your will can save your family a small fortune, said Which?. It also means that if none of the allowance is used, two parents could pass on £1m to their children tax-free when they combine the nil-rate band and the main residence allowance.
How to reduce your inheritance tax bill
The first thing to do is to make a will, said The Times Money Mentor. If you don’t state how you want your assets to be divided, the law decides for you. “That means that even more than necessary could end up going to the taxman.”
One of the simplest things you can do to avoid paying IHT is to spend your money or give it away during your lifetime, added Which?. “No tax is due on any gifts you give, as long as you live for seven years after giving them.”
If you die within seven years and the gifts are above your tax-free allowance, your estate will pay a reduced tax rate known as taper relief depending how long ago you gave the money.
Giving money to charity, political parties or local sports clubs can also reduce your estate’s IHT bill.
If you leave more than 10% of your taxable estate to one of these groups in your will, the inheritance tax rate for the rest of your estate will fall from 40% to 36%.
ISAs are a great way of keeping the taxman away from your savings while you’re alive, but they’re also tax efficient when you die, said YourMoney, “assuming you’re survived by a spouse.”
Your ISA pot can be transferred to your spouse free of IHT.
It may also be worth putting more money into a pension because they normally fall outside of a person’s estate, said Hargreaves Lansdown, “meaning there’s usually no inheritance tax to pay on them”.
A pension can be passed on to a beneficiary that you name when you start saving. Any withdrawals your beneficiaries make will usually be free from income tax, but only if you die before age 75.
Another option is to set up a trust. When you put money or property into a trust, said MoneyHelper, provided certain conditions are met, “you no longer own it.” Instead, the cash, investments or property belong to the trust and are outside anyone’s estate for IHT purposes, although you can decide how and when assets are distributed.
If you are worried about your children or grandchildren wasting the money, you could dictate that they gain access to their trust only when they turn 25.
“Trusts can be expensive to run and subject to tax charges”, Laith Khalaf head of investment analysis at AJ Bell, told MoneyWeek. If your estate is still set for a large IHT bill, you can buy an insurance policy that covers the liability. To do this, you should seek help from a financial adviser, added the magazine.
“This route offers you peace of mind that your beneficiaries won’t struggle with a huge inheritance tax bill when you die,” Khalaf told the financial publication, “but you are effectively paying at least part of that bill while you are alive through your monthly premiums, which can be substantial.”
Marc Shoffman is an award-winning freelance journalist, specialising in business, property and personal finance. He has a master’s degree in financial journalism from City University and has previously written for FTAdviser, ThisIsMoney, The Mail on Sunday and MoneyWeek. This article is based on information first published on The Week’s sister site, The Money Edit.