Director How To Avoid The Inheritance Tax in 3 steps

Tony Dhanjal

This Article Contains

The original idea of inheritance tax was that when wealthier individuals died, part of their wealth was redistributed via the tax system. Many would argue that over time the tax has shifted it’s focus and many who wouldn’t consider themselves “wealthy” are now left with an inheritance tax bill.

Considering this, it’s no surprise that people question how to avoid the inheritance tax charge in the UK? In this article we will cover the basics of inheritance tax and then look at 3 steps that can be taken to potentially reduce exposure to this death tax.

What Is Inheritance Tax?

Inheritance tax in the UK is applied to transfers of wealth. The most common example of this is on death when an individuals wealth also known as their estate is distributed to others. It can also apply to lifetime transfers such as when you make a gift to friends or family. 
 
Certain transfers are considered exempt from inheritance tax altogether including:
 
  • Transfers made between spouses and civil partners
  • Gifts made to a charity, community amateur sports clubs or qualifying political parties
  • Gifts to museums and other national interests
There are also exemptions available on some smaller gifts, such as:
 
  • Small gifts less than £250 in value
  • Gifts on marriage and civil partnerships – limited to £5,000 for gifts to children, £2,500 for grandchildren or other direct descendants and £1,000 for anyone else
  • Some transfers made out of disposable income 
Most other transfers of wealth are considered to be lifetime transfers for IHT and may be incur a tax charge. To learn more about this subject check out the full course from The Accounting & Tax Academy.
 

Chargeable lifetime Transfer V Potentially Exempt Transfer

A lifetime transfer that isn’t otherwise exempt will either be a chargeable lifetime transfer or a potentially exempt transfer.
 
Chargeable lifetime transfers only usually occur on transfers made to certain types of trust and would be considered for IHT immediately although a charge won’t always occur. To determine if any tax is due you must first consider all chargeable lifetime transfers made in the 7 years prior to the current transfer. The nil rate band of £325,000 (21/22) is then applied in chronological order to the gross value of these transfers. Any amount of the gross value of the current transfer that is not covered by the nil rate band is taxed immediately at a rate of 20%. Additional tax may then be payable if the transferor dies within 7 years of the transfer.
 
Potentially exempt transfers are far more common and apply to any transfer that is not a chargeable lifetime transfer. There is no immediate tax charge to a potentially exempt transfer. Instead the PET will only be considered for inheritance tax if the individual dies within 7 years of the transfer. In that case the potentially exempt transfer converts to a chargeable lifetime transfer and would be considered for IHT on death as detailed below.
 

IHT On Death

Death is the most common trigger for an inheritance tax charge as the estate is distributed. The process to calculate an IHT liability on death is to:
 
  1.  Consider all lifetime transfers within 7 years of death with no distinction being made between chargeable lifetime transfers and potentially exempt transfers (this is because a PET essentially becomes a CLT if the transferor dies within 7 years)
  2. Calculate the tax charge on each CLT in chronological order. The first £325,000 of chargeable transfers is covered by the nil rate band meaning no tax would be payable. Any chargeable transfers in excess of this are taxed at 40%
  3. Where a transfer took place more than 3 years prior to the date of death then taper relief can be applied to the tax amounts. Tax already paid is taken into account here but If the tax originally paid exceeds the amount calculated on death then no refund is available for overpaid tax
  4. If any nil rate band remains then it can be set against the value of the remaining estate. Anything in excess of the remaining nil rate band is taxed at 40%
Although an individuals nil rate band is currently £325,000 (21/22) it is possible to inherit unused nil rate band from a deceased spouse or civil partner so in reality it could be as much as £650,000. The same rules apply to the residence nil rate band which applies when passing some property that has been lived in by the deceased to a direct descendant. The RNRB is currently £175,000 (21/22).

 

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How To Avoid The Inheritance Tax Charge
The impact of inheritance tax on an individual will depend a lot on their personal circumstance and the make up of their estate. A previously married individual who passes on property to a a descendent could benefit from up to £1m of combined NRB & RNRB (as above) before having to pay any tax. Whereas another unmarried individual who’s estate is made up of cash would only benefit from a NRB of £325,000 before paying tax.
 
This may seem a little unfair but it certainly leaves us with a number options on how to avoid the inheritance tax charge.
 

1. Make Small Gifts & PET’s

Of course gifting away assets isn’t something that should be done without due consideration but the use of small gifts and potentially exempt transfers to family and friends can be a very tax efficient way of how to avoid the inheritance tax charge.

Technically an individual can make as many small gifts as they like providing they don’t exceed the £250 per person per tax year limit. Where the limit is exceeded the exemption won’t apply at all to that person so you can’t reduce the value of a £500 gift to £250 by applying the exemption.

The main restriction to consider is 7 year rule which can limit the effectiveness of a PET if the transferor dies suddenly but typically providing the transferor survive at least 3 years then there should be some tax benefit to be had.

The use of potentially exempt transfers to reduce the value of an estate is without a doubt the most effective tool available on how to avoid the inheritance tax charge.

2. Estate Shaping

Another answer on how to avoid the inheritance tax charge is to shape your estate in a more tax efficient way that would allow it to qualify for more exemptions and allowances.
 
  1. Consider owning property (if you don’t already). This could allow you to utilise the residence nil rate band in addition to the nil rate band if you meet the qualifying criteria
  2. Consider purchasing assets that may qualify for business property relief or agricultural property relief such as an interest in a business or certain woodlands. Again there are certain conditions that would need to be met
Estate planning like this usually requires advanced planning and lots of consideration to be executed effectively but if done well is certainly a solution to the question of how to avoid the inheritance tax charge.
 

3. Give More To Charity

Giving more money to charity might not be something you considered on the subject of how to avoid the inheritance tax charge but in certain situations it can actually reduce an overall liability and increase the amount the gets retained by those named in the will.
 
Where an individual leaves 10% or more of their net estate to charity the headline rate charged to the remaining estate on death is reduced from 40% to 36% so where it is already planned that part of the estate will be left to charity but the 10% threshold isn’t quite met it can be beneficial to increase the charitable donation and then benefit from a lower rate of tax.
 
One difference with this technique when compared to the previous techniques we looked at is that even after the individual is deceased, those in charge of the estate can elect to increase a charitable donation. Whereas the other techniques would require advanced planning. 

Watch our in-depth video on How To Avoid The Inheritance Tax

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Practice based accountant with over 10 years experience, specialising in SME's, Freelancers and Personal Tax. "I take pride in proactively recognising tax planning opportunities on behalf of clients to help them operate more efficiently."

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