Life, as we all know, is 100% fatal, whether you are unfortunate enough to die young, or, as Ronald Reagan put it, “you leave it until the last minute”. On the other hand, with a little planning most taxes – while tricky to avoid altogether – can either be deferred, or, better still, cut. That is particularly true of inheritance tax (IHT), and yet, according to IFA Promotion, the industry body for independent financial advisers, almost 75% of us do nothing about it. As a result, Scottish Widows estimates that 40% of us end up paying unnecessarily. The result is a windfall of around £1.5bn per year for the Treasury. So, unless you want the government to end up with your hard-earned cash when you die, it’s time to start planning. Here is a brief guide to how this tax works and some tips to help reduce the bill. Needless to say, you should seek tax advice from a financial adviser or accountant before making any final decisions.
Inheritance tax: who and what is liable
A common mistake is not realising that if the deceased was born in the UK and/or spent much of their life (strictly, more than 17 years out of any 20) in the UK then they are likely to be classed as ‘UK domiciled’ for IHT purposes, irrespective of the country in which they died. Be warned, domicile – your ‘permanent legal home’ – is tough to change and the rules are complex, so if in doubt, seek advice. The bad news is that UK domicile status means worldwide assets, not just UK-based ones, are vulnerable, so you can’t reduce IHT by relocating assets overseas.
Responsibility for dealing with IHT normally lands on the shoulders of the immediate family or relatives of the deceased. On death, an ‘executor’ (typically a family member, usually helped by a solicitor) is tasked with arriving at an open market value for the entire ‘death estate’ of the deceased. This includes all assets such as property, shares, cash and so on, less any outstanding liabilities in the form of unpaid mortgages, loans, bills and funeral expenses. The estate can’t be distributed according to the terms of the will until IHT has been declared and paid.
Inheritance tax: the calculation
IHT is a pretty brutal tax because it is charged at the thumping rate of 40%. The good news is that everyone gets an allowance of £300,000. The Treasury increases this somewhat arbitrary limit each year, but be warned – over the last decade it has not kept pace with general inflation, let alone soaring house prices. This is how it works. Suppose the assets of the deceased are worth £500,000, with unpaid debts of £50,000; the death estate is then £450,000. From this, £300,000 is deducted, leaving £150,000, which is taxed at 40%, giving rise to a tax bill of £60,000. This must be paid to the tax office (HMCE) within six months from the end of the month of death. So if someone dies in January, the entire £60,000 is payable no later than 31 July. The executor can negotiate to defer some of this by paying in instalments – but bear in mind that HMCE will then charge interest on the outstanding amount. In other words, when you die, 40p in every £1 of your assets over £300,000 will end up in the government’s coffers. It’s not a pleasant thought. So how can you reduce the bill?
Inheritance tax: give your assets away now
You can give away anything – cash, property, cars – of any value, to anyone you like, and potentially escape IHT altogether. Sound too good to be true? That’s because it is. Firstly, gifts with strings attached don’t count, so forget giving your house to a child and then insisting on continuing to live in it, for example. Secondly, the exemption only works if you survive at least seven years after making the gift – so you can’t just sign everything over on your deathbed. Should you die before the seven years are up, the recipient can be taxed on the value of the gift up to the full 40% rate, with taper relief depending on how far through the seven years you survived. Predicting your own death is, of course, pretty tricky, so if you plan to take advantage, start making gifts as soon as possible and then stick with the fitness regime! Again, take some tax advice on big gifts, because although you can reduce IHT by giving away an asset, you might be hit from another direction, with a capital gains tax bill.
For example, suppose you bought a holiday home in 1995 for £90,000, which you now plan to give away to one of your children in 2007. Similar properties are now worth, let’s say, £250,000. If you survive another seven years, until around 2014, there shouldn’t be any IHT payable on the gift. But as a ‘UK resident’ you will almost certainly incur a capital gains tax bill this year, based on the increase in value of £160,000, because gifts like this are treated by the taxman as a ‘deemed disposal’. Sneaky, but true, I’m afraid. Not all gifts are potentially taxable though. You can give away £3,000 a year to any one person you like and, if you forgot to do it last year (the tax year runs from 6 April to 5 April), you can bring forward one year’s allowance unused, so this year’s gift could be £6,000. On top of that, you can make an unlimited number of ‘small’ gifts to anyone who is not the recipient of the aforementioned £3,000, as long as it is no more than £250 per year. This can be useful around Christmas time for people with lots of children or grandchildren, for example.
Then there are wedding gifts. Parents can give £5,000 each, grandparents and other ancestors £2,500 each and anyone else – perhaps a brother or sister – £1,000 each as a wedding (or civil-ceremony) present with no IHT implications. However, make sure you do it on, or before, the wedding date and, as with all tax matters, keep a record of the amount and date of the gift. Another possibility for people who are fortunate enough to have high earnings is an exemption for ‘regular gifts out of surplus income’, perhaps used to cover life assurance payments or birthday and anniversary presents. However, this little-used rule requires you to document all such gifts and be able to prove that you can afford to give away the cash without any impact on either your day-to-day expenditure or capital. Last, but by no means least, you can give any amount to charity safe in the knowledge that there will be no IHT liability.
Inheritance tax: doubling up
Given the huge increase in UK property prices in recent years – according to Thisishouseprices.co.uk, the average detached house costs over £270,000 – many couples now own assets valued above £300,000. Although each spouse gets a £300,000 allowance on death, taking advantage of both isn’t simple. If, say, a husband dies, all of his assets – £600,000 worth, for instance – can be left to his wife. Transfers between spouses are exempt from IHT, so nothing is payable – yet. The problem arises on the second death, when (assuming no change in asset values) the death estate, now all in the widow’s name, is still worth £600,000. Take off her £300,000 allowance and you have a £120,000 tax bill (£300,000 x 40%). So ideally a couple should both use their £300,000 allowance and reduce the tax bill to zero – but how?
One solution is not to leave everything to your spouse. Provided a will has been drawn up, a husband could leave perhaps £300,000 of investments and cash on his death to his children, rather than all £600,000 to his wife. That way his £300,000 allowance is used up and the remaining £300,000 of assets, perhaps the family home, is left to his wife tax-free. When she dies, her own £300,000 exemption will be available to negate any tax problem. One drawback of leaving assets to children in this manner is that it may leave the wife short of cash to live on following the death of her husband. However, there are ways to ensure that the wife can continue to occupy the family home, have sufficient cash and still use both £300,000 exemptions.
Inheritance tax: the deed of variation
This is a pretty handy IHT solution, although rumours persist that the Treasury might change the rules. Provided all affected parties agree (ie, the wife and children), the husband’s original will – leaving everything to his wife – can be varied up to two years after his death to change the way assets are distributed. If, for example, it becomes clear after his death that his wife has more than enough to live on, it might have been better if some of his £600,000 of assets had passed to the couple’s children instead of to his wife on death, as per the original will. Once the will has been varied (‘by deed’) his £300,000 allowance can be used retrospectively, rather than wasted.
Inheritance tax: the discretionary nil-band trust
This is another way to use both allowances, although after a recent court case (Phizackerly versus HMCE) you’ll need professional advice to get it right. But for a relatively small solicitor’s fee, the saving of up to £120,000 more than compensates. The scheme works best if a husband and wife have split ownership of their assets roughly 50:50 so the family home, for example, is shared as ‘tenants in common’. This time if, say, the husband dies first, his assets, including any share of the marital home, are transferred tax free (up to £300,000) into a discretionary trust for the eventual benefit of his surviving spouse and children. Once the husband’s assets are in the trust, his widow can, if necessary, apply for a loan from the trust to cover her own financial needs and living expenses. On her death, this loan is repaid having been deducted, as a liability, from her death estate, which ideally reduces the value of her remaining assets to, or beneath, her nil-rate band of £300,000. These assets and the trust’s £300,000, now repaid from the deceased wife’s death estate, are then distributed among the couple’s heirs free of any IHT.
Lastly, there are a number of investments that qualify for ‘business property relief’. The main ones are shares in unquoted firms and Aim shares (though not all of these are eligible). These are worth considering, as long as you remember that the tax break is given largely because these are shares in high-risk firms.