Here’s how early estate planning can help reduce the impact of inheritance tax

Inheritance tax has been a hot topic in the news since Reeve’s budget announcement on October 30th. The government has come under scrutiny for the changes they have made and the perceived unfair treatment of particular sectors of society. 

But what is inheritance tax? How has it changed? And how can it be avoided?

This article aims to address these questions.

What is inheritance tax and what are the thresholds and allowances? 

Inheritance tax (IHT) is a tax on the estate (property, possessions and money) of someone that has died. The standard rate for inheritance tax is 40%, and this tax is typically paid by the beneficiary (heir) of the deceased. 

Not all assets are going to be subject to inheritance tax upon death – we are given some allowances to shield us against the tax that nobody wants to pay. 

Each person has an allowance of £325,000 called the nil-rate band which is exempt from IHT. 

Homeowners are entitled to an additional allowance of £175,000, known as the residence nil-rate band. However, this allowance can be tapered depending on the total value of your estate. The residence nil-rate band decreases by £1 for every £2 above of your estate which is over the net value of £2 million. Therefore an estate worth £2.35 million will not benefit from this allowance. 

These allowances can be shared between spouses and civil partners, which can reduce the overall inheritance tax liability. 

Let’s illustrate this with an example: Joseph and Mary, a married couple, own a home valued at £500,000. The remainder of Joseph’s assets amount to £400,000, and Mary’s amount to £250,000, and they each have no liabilities. 

As you can see from the table below, on Joseph’s death his allowances are passed onto Mary, so there is no inheritance tax to be paid immediately on Joseph’s death. Then, when Mary passes, £150,000 of their joint estate exceeds the available allowances, resulting in an inheritance tax charge of £60,000.

How have things changed with the new budget? 

Before the budget, it was estimated that only 4% of households paid inheritance tax. However, new projections from the Institute for Fiscal Studies (IFS) suggest that this figure could rise to 7% by 2032. The main reason we are likely to see an increase in people paying inheritance tax is because pensions are now treated as part of the estate for IHT. 

Under the current rules up until April 2027, pensions can be passed on to beneficiaries exempt from inheritance tax. If one were to pass before the age of 75, the pension would be passed on tax free. If one were to pass after the age of 75, then the beneficiary would receive the pension with an income tax charge at their marginal rate. 

To illustrate this, I have created a table below to show how much of a £100,000 pension would be received by a beneficiary, who is an additional rate taxpayer, under different scenarios. 

In 2027 this will all change. As pensions will be brought under the estate, there may be a 40% IHT tax charge due when passing on pensions, if the value of the pension assets are above the allowances available. 

So when people die before the age of 75, beneficiaries could see a tax charge of 40% when receiving this pension. In the table above, assuming the nil-rate band and residence nil-rate band have been exceeded, the beneficiary would pay £40,000 in inheritance tax on a £100,000 pension, if their family member were to pass before the age of 75. 

The rules around death after the age of 75 are a bit more unclear, and there has been a lot of discourse around the potential for a double taxation in this case. 

Upon passing, there would be an immediate 40% inheritance tax liability, and then a further income tax charge at the beneficiaries marginal tax rate. 

In a worst case scenario, the tax paid could be as high as 67%. For example, if someone was to inherit a pension worth £100,000 under these conditions, £40,000 would be paid in inheritance tax straight away. 

Then, if the beneficiary was an additional rate taxpayer, a further income tax charge of £27,000 (45%) would be due, thus bringing the total amount paid in tax to £67,000 on £100,000 (67%).

In addition to these changes, allowances for business tax relief, agricultural tax relief and AIM shares have also been reduced. Any qualifying individuals must pay 20% tax on assets above £1 million, compared to no tax previously. This explains why we have seen farmers take to the streets of London in protest. 

Best practices for reducing IHT bill 

It’s common to think that these tax charges are unavoidable, but with early planning, there are ways to potentially reduce the impact of inheritance tax.

Gifting is one of the key ways that one can reduce the value of their estate, and there are various different allowances available each year to aid this. 

For example, each person has an annual exemption of £3,000 per tax year, which allows you to give up £3,000 worth of money or assets to either a single individual or multiple people. In addition to this, you can carry forward any unused gift allowance from the previous tax year, and so, if unused, you could gift £6,000 in total to keep out of reach of inheritance tax.

Other allowances include the small gift allowance whereby you can give as many gifts as possible up to the value of £250 per year per person, only if another allowance has not been used on this person. 

Gifts for weddings or civil partnerships are also allowed up to the value of £5,000 to a child, £2,500 to a grandchild or £1,000 to any other person.

The use of these gifting allowances can be crucial for estate planning, but there are only so many gifts that can be made each year, and so many people you know are getting married. So what can people do other than making smaller gifts? 

There is also the option to gift beyond your allowances. However, these gifts will be subject to the seven-year rule. Any gift made will not be subject to inheritance tax as the donor outlives the gift by seven years. These are known as Potentially Exempt Transfers (PETs). 

Crucially, in order to qualify as a potentially exempt transfer, the donor must not hold any interest in the gift given. By way of example, if someone were to gift their house to their son and they continued to live in the house after gifting it, this would not qualify as a potentially exempt transfer as there is still an interest in possession. 

Furthermore, beneficiaries may be able to claim relief on their inheritance tax bill, if the donor dies within the seven-year period. The amount of reduction will depend on the amount of time that has passed since the gift was made. 

The table below outlines the different inheritance tax rates enforced, depending on how long ago the gift was made. 

The seven-year rule is one of the most important tools used in estate planning, and with the new changes to inheritance tax that the government is bringing in, this rule will only become more of a staple. 

Another way where you can reduce your inheritance tax bill is through the use of trusts. Trusts are a legal arrangement you can create whereby your assets are held and looked after by trustees for the benefit of your beneficiary. If assets are held in trust they are technically no longer yours and so can be beneficial for inheritance tax purposes. However, it is important to note that gifts put into trust are still subject to the rules above, and some trusts have their own tax rules which may make them not as tax efficient as you would think. As with all things, if you are unsure I would recommend speaking with a professional before making any decisions. 

How will things change moving forward? 

Adjustments to inheritance tax rules will have an impact on how people view estate planning. In particular, pensions are likely to no longer be an attractive estate planning tool. However, these changes to the rules should not dishearten investors, as there are still ways that one can reduce their inheritance bill.

All that has really changed is the need for earlier and more thoughtful planning on how you would like to pass on assets across generations. 

We are likely to see that people will be looking to pass on assets to their children earlier than usual. In particular, this is likely to take the form of people tending to drawdown from their pensions earlier and make gifts to their children to take advantage of the seven-year rule and gift allowances. 

Previously, we have seen that people tend to draw down from their pensions last, as these investment vehicles were exempt from inheritance tax. Now that this has changed we could see pensions becoming the first to be accessed. 

However, while drawing from a pension to gift early may seem beneficial from an inheritance tax perspective, there are also income tax implications that must be taken into consideration when formulating this plan. 

Similarly, there is longevity risk associated with taking funds from your pension too early. One would not want to be in the position where they are running out of funds within their retirement. These factors show the importance of proper planning, and it is always recommended to seek the advice of an expert to aid this.

While the changes made within the budget have reduced the amount of tax-free havens within estate planning, these changes by no means take away from the importance of investing within tax wrappers. ISAs remain unchanged by the budget, with the £20,000 allowance for tax-free growth continuing to be a leading tool in building wealth over the years. 

Pensions were not so lucky, and while they are no longer as useful a tool in estate planning, people should not be put off by pensions: they remain one of the most crucial vehicles for growing wealth over time. Like the ISA, they benefit from tax-free growth, and thus are not subject to fiscal drag from things like income tax and capital gains tax (another which has increased with the budget). 

Pensions continue to benefit from government income tax relief on pension contributions, which can aid in reducing your own tax burden, while also increasing the compounding effect over the years to stimulate further growth. Most importantly, pensions have a generous allowance of up to £60,000 a year (three times that of the ISA), allowing you to build up a large portion of tax-free savings each year. 

At present the changes to inheritance tax made in the Budget are subject to technical consultations, and so it is yet to be clear how these adjustments will look in practice, as they could be subject to change. 

What we can say is that this Budget will likely change the way that we approach estate planning. We may see people take from their pensions earlier to gift assets to their loved ones, taking advantage of gift allowances and the seven-year rule. 

This change should not alter how people choose to invest, as tax wrappers such as ISAs and pensions are still the most tax efficient vehicles to be used for increasing wealth through life, and – with the right planning – across generations as well.