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Five simple ways to avoid the inheritance tax trap
20 December 2024
When families plan for retirement, they often spend more time considering how to generate wealth than how to protect it. However, without appropriate foresight, families can end up paying more inheritance tax upon death than they need to and passing on less wealth to their loved ones in the process.
Inheritance Tax (IHT) is a tax due on the estate (i.e., property, money and possessions) of someone upon their death in the UK, which is usually charged at a rate of 40% for estates with a value of over £325,000. This tax can lead to family members having to cover large bills from their loved one's estates, causing additional stress at an already difficult time.
William Stevens
Partner, Head of Financial Planning
Many families fall into the trap of paying more tax than they need to because they do not know that making financial gifts while you are still alive can help reduce the size of your estate and, therefore, the amount of tax due upon death. As a result, taking advantage of these opportunities is critical to protecting your wealth and maximising the inheritance you can pass on to loved ones.
In this blog post, we outline five tax exemptions families can use to mitigate IHT.
Capital at risk.
Please be aware that we usually recommend investing to help you meet your financial goals, and the value of your investments may fall as well as rise. In addition, this content reflects our current understanding of UK legislation and only impacts those within the UK tax system. Tax treatment depends on personal circumstances, and the rules may be subject to future change.
1. The seven-year rule
Perhaps the best-known tax exemption for IHT mitigation is the seven-year rule. Under this rule, any gift, of any amount, that doesn’t qualify for an exemption or other relief, is potentially exempt, and falls out of your IHT estate completely after seven years (with a tapered amount remaining chargeable between three and seven years).
2. The annual exemption
Another simple way to benefit from tax relief when making a gift is to take advantage of the annual exemption. This exemption allows you to make gifts worth £3,000 in each tax year (to one person or divided between multiple people) and they’ll be immediately outside your IHT estate. The exemption can be carried forward for one year, so if you were to make only £1,000 of exempt gifts in one tax year, you could make up to £5,000 in the next.
3. The small gifts exemption
The small gifts exemption can be especially helpful for those who have already taken advantage of the first two exemptions in this article or plan to make a series of smaller gifts, as it allows you to make an unlimited number of gifts of up to £250 per recipient in each tax year. The £250 does not partly exempt a larger gift, so if you gift, say, £400, to one person, the whole £400 remains in your estate (as opposed to £250 being immediately exempt and the ‘excess’ £150 remaining in your estate). This also means it can’t be combined with the annual exemption (i.e. it doesn’t extend the £3,000 to £3,250 for one recipient).
4. Marriage exemption
An exemption is also available for those legally married or in a civil partnership. Gifts made (or bindingly committed to) on or shortly before a marriage, and specifically for that marriage, are outside of your IHT estate from the date of the marriage. Each individual can gift £5,000 to a child, £2,500 to a grandchild or great-grandchild, and £1,000 to anyone else. These rates have remained unchanged since they were introduced in 1984, and only the excess amount remains in your estate if gifts are made above the threshold.
5. Normal expenditure out of income exemption
The final in our list of exemptions, and often the most helpful for avoiding the IHT trap, is the normal expenditure out of income exemption. While making the most of it requires a bit more planning than the other exemptions and evidence of expenditure, the size of the exemption is limited only by the size of your surplus income.
If you make a gift that: a) is part of your normal expenditure; b) made out of income (not capital); and c) leaves sufficient income to maintain your usual standard of living, then that gift falls immediately out of your estate for IHT purposes. Nearly anything can count as ‘normal’, provided you can evidence that it forms part of a pattern. That could be regular contributions to a savings plan for someone or taking the whole family on holiday every few years.
The gifts must be planned in a way that clearly establishes a pattern, as you need to plan the income that generates the surplus to make the gifts. For example, you could switch investment strategies to higher-income-producing assets or draw from a pension income that was otherwise unnecessary.
Making the most of planning
While the thought of paying an IHT bill can be daunting, the good news is you can take steps today to mitigate the impact upon death – and the even better news is that these wealth transfer strategies can help to enrich the memories you have as a family while everyone is around to enjoy them.
Estate planning is an essential task for those seeking to manage family finances responsibly, and taking advantage of these opportunities is critical to protecting your wealth and maximising the inheritance you can pass to loved ones.
We often find that the sooner you start planning, the more you can do. While these strategies may not be suitable for everyone, planning opportunities are usually available to most families to make the most of their money – regardless of their age or stage of life.
Our Wealth Planners regularly help clients develop strategies to achieve their financial goals, from mitigating IHT to forecasting how much you will need to save for retirement. Get in touch to book a consultation with one of our Wealth Planners (the first one is free) and learn how our Wealth Planning Service could help you structure your family finances more effectively.
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