Inheritance Tax (IHT) is a controversial issue which leaves many people wondering how they can reduce the amount that will be lost to the government when they die.
The good news is that IHT only affects estates worth more than £325,000. The bad news is that it is easier to breach this threshold than you might think. Your home alone could be worth more than that amount.
It may be possible to reduce your estate’s worth and avoid paying high amounts of IHT by gifting amounts to family, friends and charity before you die. Plus, seeing the impact that the extra cash can have on loved ones is always rewarding. However, it is essential to understand the rules surrounding gifts and whether you can realistically afford to give them away.
How is Inheritance Tax (IHT) calculated?
Before deciding whether making gifts is the right option, you need to calculate whether your estate will be liable for Inheritance Tax and, if so, how much.
On a fundamental level, Inheritance tax applies to estate value over the nil rate band of £325,000 and is currently set at 40%. So, on an estate worth £500,000, the IHT will apply to £175,000, and the total IHT payable will be £70,000. This is 40% of the £175,000 by which the estate exceeds the nil rate band.
However, the calculations are a lot more complicated than this would suggest. For example, if you are leaving your primary residence to ‘direct dependants’ you can apply for the residence nil rate band relief which will increase the nil rate threshold by £100,000.
To reduce payable Inheritance Tax, you may consider reducing the excess estate value by gifting amounts to loved ones while you are still alive. However, you need to be aware of how much you can gift each year and how gifts can potentially be taxed after your death, even though they are not in your possession at the time of death.
How does gifting work?
Gifts are sums of money or assets of value which are directly transferred to another person or organisation with no financial value given in return.
There are several ways in which gifts can be given to both loved ones and organisations during your life, which will reduce the value of the estate you leave behind and consequently reduce the IHT payable.
There are a range of IHT exemptions, which can be used to provide loved ones and causes with gifts which do not incur tax liability, such as:
- Annual exemption: Each tax year you can give gifts up to the amount of £3,000 which are immediately outside of your estate value. Unused yearly exemption from last year can be used to increase the current year’s exemption up to £6,000. However, this amount cannot then be carried over for a third
- Gifts for weddings and civil ceremonies: The limits for this depends on your relationship with the recipient. You can give children up to £5,000, grandchildren and great-grandchildren up to £2,500 and other individuals up to £1,000 each.
- Assisting with living costs: It is possible to make gifts to children under the age of 18 and elderly relatives, to support their quality of life.
- Small gift exemption: During the tax year, you can give gifts of amounts less than £250 as often as you wish – even to the same person. However, this does not apply if the recipient has already benefited from a gift covered by the other exemptions in this list.
- Gifts from income: Birthday and Christmas gifts are exempt from IHT liability – as long as your standard of living is not affected by giving such gifts.
- Gifts to charity: You can gift as much of your worth to charity as you wish, without incurring IHT liability on the amounts donated. A charitable donation of 10% or more of your estate’s value after death reduces your IHT liability to 36%. However, it can be better for both you and the recipient organisation, if these donations are made during your lifetime. This is due to the negligible difference in total tax paid, while Gift Aid and other charity benefits increase the total amount received by the charity.
While financial gifts do not incur IHT liability when given; they may be subject to the seven-year rule, which states that gifts provided in the seven years before the donor’s death are potentially subject to IHT, hence they are called ‘Potentially Exempt Transfers’.
The ‘taper relief’ scale dictates the percentage of IHT payable on gifts, depending on how many years before the donor’s death they were given. If death occurs within:
- less than 3 years – 40%
- 3 – 4 years – 32%
- 4 – 5 years – 24%
- 5 – 6 years – 16%
- 6 – 7 years – 8%
- 7 + years – 0%
Gifts which you retain an interest in are not exempt from IHT liability. This is referred to as ‘reserving a benefit’ and includes property which is formally and legally transferred to children or grandchildren, but in which you continue to live on a permanent basis. This home is still legally a part of your estate.
Other ways to avoid or reduce IHT liability
Giving financial gifts to loved ones is not the only way to reduce the IHT liability of your estate, you can also:
- Ensure that your estate is never worth more than £325,000
- Leave your estate, in its entirety, to an exempt party, such as a:
- Civil partner
- Community sports club
- Leave 10% of your estate to charity, which will reduce the IHT liability by 10%. This will mean that 36% of your estate will be lost, rather than the full 40%.
- Claim the residence nil band rate by leaving your home to your children. This exemption applies to biological children, stepchildren and both adopted and foster children.
Is making a gift right for you and your family?
Being able to help family and friends and see the joy that a financial boost can bring to their lives is a fantastic feeling. However, none of us has a working crystal ball, and as such, we do not know what the future has in store for us.
When deciding whether you should make gifts to your loved ones to offset your estate’s IHT liability, ask yourself these two important questions:
- Can you afford it?
- Are you giving the right amount to the right person, at the right time?
For further advice about estate planning and Inheritance tax issues, contact us using the number at the top of the page.