Reports suggests the Chancellor could target Inheritance Tax (IHT) in the upcoming Budget. IHT bills are up £400m in the first half of this financial year, compared to 2023/24 with HMRC tax receipts up across the board by over £11bn between April and September.
IHT is only part of the death taxes picture, with CGT uplift on death, pension death benefits rules and an array of gifting rules and other reliefs playing a part. The complex rules and the importance of legacy planning means financial advice can be crucial in this area.
Charlene Young, AJ Bell pensions and savings expert says: “IHT is one of the UK’s most hated taxes. At 40% it is one of the highest headline rates in the UK’s gamut of personal taxes. People detest the idea that, having paid tax throughout their working lives, their assets remain within the taxman’s clutches even beyond the grave.
“The latest figures from HMRC illustrate the scale of the growing tax take, largely driven by frozen thresholds. Unfortunately, the upcoming Budget is likely to contain more pain for taxpayers and some reports suggest that IHT could be one of the taxes in the Chancellor’s crosshairs.
“Although IHT is widely disliked, it’s worth pointing out that the tax is paid by very few households. Only a tiny fraction of families ever have to pay any IHT at all due to the reliefs available that mean a homeowning couple can normally pass on £1 million before IHT kicks in. And for those with larger estates, there are various strategies available to allow people to give money away and pass on assets tax efficiently.
“In fact, some would argue that the purpose of IHT is in part to discourage people from hoarding assets, and instead prompt them to spend, give and invest during their lifetime.
“A review of death taxes would likely involve looking at a range of reliefs and interacting taxes, not only the headline rate of IHT and the existing nil rate bands.”
IHT is increasing anyway
“Taxpayers have had to get used to fiscal drag and, although it’s a phenomenon normally associated with tax on incomes, families inheriting money will feel the impact too.
“Everyone can pass on up to £325,000 before any IHT is due, although this IHT nil rate band has been frozen since 2009. The residence nil rate band (RNRB) has been available since 2017 and gives a boost of up to £350,000 per couple if they leave a property to their direct descendant(s). Had both bands been uprated with inflation rather than being frozen in 2020, a couple could pass on an estate worth nearer £1.5 million today.
“The frozen limits are one of the reasons that the nation’s IHT bill is rising, with figures showing the tax take is up £400 million in the six months to September this year, compared to the same period in 2023.
The effective rate of IHT paid by estates
“One of the issues with IHT is that larger estates actually often end up paying a lower effective rate than those with modest wealth.
“What does this mean?
“As with any tax, while a headline rate applies it’s also worth looking at the effective rate to get a sense of how the tax really works.
“The effective rate is the actual tax paid as a percentage on all the assets or income in question. For example, a £1.5 million estate paying a total of £150,000 in IHT has an effective tax rate of 10%, well below the headline 40% rate. That reflects the net impact of the nil rate band and any other exemptions and reliefs they have been able to use.
“When it comes to IHT the average effective rate for estates in 2021/22 was 13%, thanks to the combination of tax-free allowances, exemptions, and reliefs used.
Source: HMRC, Average effective tax rate (AETR) for taxpaying estates.
“The effective rate was lower for smaller taxed estates – at around 4% – which were only just over the IHT exemption threshold. The effective rate rises as the value of the estate goes up, with the families paying the heftiest death duties to the taxman handing over more than 25%.
“The worst hit tend to be estates worth around the £3-4 million mark, due in part to the fact that the RNRB is tapered down for estates worth over £2 million at a rate of £1 for every £2 over the threshold. For couples, RNRB is lost altogether if the surviving spouse’s estate is over £2.7 million. For estates worth over £2 million the effective rate was an average of 24%.
“However, the effective tax rate actually then falls for larger estates. That’s because larger estates tend to be more likely to be in a position to make use of reliefs for farmland and business assets.
“The Chancellor might, therefore, look in the round at IHT and decide to tweak and reform reliefs and use of trusts, which tend to be tools used by wealthier households. This could potentially be framed as a tax on the wealthiest, sparing the middle classes. Although clearly that depends on your perspective.”
How families plan ahead
“There’s an array of reliefs and planning tools that can be used to mitigate IHT and pass on assets to your loved ones efficiently.
“Aside from the universal nil rate band, and the potential to use the additional residence option to increase it, investors can make plans in their lifetimes to benefit from reliefs and exemptions when they die and pass on wealth.
“The most important apply to transfers between spouses and civil partners. The nil rate band is transferable between partners. This effectively means that when one partner dies, their spouse absorbs their assets and their partner’s nil rate band. Everything is rolled up until the death of the surviving partner, at which point the couple’s combined nil rate band can be applied to their total estate.
“The nil rate band of £325,000 per person is effectively doubled to £650,000 for a couple. In addition, they can claim up to £175,000 per person RNRB against their home if it is left to their direct descendants, creating a combined total of up to £1 million which can be passed on free of IHT.
“Any gifts you make to your spouse or civil partner in your lifetime or on your death are exempt from IHT, assuming they are also UK domiciled. Crucially though, this exemption doesn’t apply to gifts between unmarried partners, even if you have lived together for many years.
“Agricultural and business property relief (BPR) combined saved wealthy families from paying IHT on around £4.4bn of assets in 2021/22.
“BPR was worth £2.9 billion and used by 4,170 estates, making it the second most valuable of all the IHT reliefs. Full IHT relief can be available for the business assets of trading companies held for over two years before death. Land and machinery can benefit from a 50% reduction in taxable value, meaning family-owned businesses are not faced with the pressure of stopping trading or being sold to fund IHT bills. Shares in unquoted trading companies also qualify, along with shares on the UK AIM market, meaning the relief is available to private investors too. Reliefs available for agricultural property work in a similar way.
“There are also exemptions available for gifts to qualifying charities – something 9,780 estates made use of in 2021-22 to a value of £2.1 billion, up over 16% on the previous year. Plus, if at least 10% of the net estate is gifted to charity the rate of any IHT due on the remaining estate is reduced to 36%.
“Families planning ahead will also often make use of gifting to reduce the size of their estate. Gifts are subject to taper relief, which effectively means that anything gifted is removed from your estate for IHT purposes provided you live for seven years. If the individual dies before then taper relief applies on a sliding scale – gifts made 3 to 4 years before death are taxed at 32%, falling to 8% after 6 years, and eventually 0% after 7 years.
“Some reports suggest taper relief could be reformed to lengthen the timeframe and adjust the sliding scale. That would mean families need to plan ahead sooner to make estate planning effective.”
Annual gifts
“Anyone can gift up to £3,000 a year, either to one person or split between multiple people, without it being considered for inheritance tax purposes.
“You can also give unlimited gifts of up to £250 per person, if you haven’t used another allowance to make them a gift.
“You can also gift extra amounts to someone getting married or entering a civil partnership. These are up to £5,000 for a child, £2,500 to a grandchild or great-grandchild or £1,000 to anyone else.
“The effect of gifting is to remove money from your estate, meaning that you have less taxable assets on death.
Gifts from income
“You can make regular gifts from your income, and these will be tax-free, provided they don’t reduce your standard of living. Do make sure you keep good records of you regular income and these outgoings as whoever is taking care of your estate admin will need to declare them as part of any IHT return.
“If you want to make substantial gifts over these limits and allowances then you need to be aware of the seven- year rule. If you die within seven years of giving these gifts, IHT is due on a sliding scale known as taper relief.
CGT, pensions and trusts
“The complex nature of the tax system means IHT interacts heavily with rules around pensions on death, Capital Gains Tax (CGT) and trusts.
“Pensions aren’t normally treated as part of your taxable estate, but are instead subject to their own rules on death. These are complex in and of themselves, but the key premise is that pension benefits can normally be paid out to your family tax free for those who die pre age 75, or at the beneficiaries marginal rate thereafter.
“Pensions can be an extremely effective estate planning tool as a result. Although again, the Chancellor may consider this if an over-arching review of death taxes were considered.
“Likewise, under the current system CGT is effectively overlooked on death. CGT ‘uplift’ means that on death, no CGT is payable when the assets transfer to the next generation and the value of the asset is rebased meaning any gains until that date are wiped out for tax purposes.
“Depending on the individual’s circumstances this often means it’s more tax effective to hold onto an asset and pass it to your family when you die, rather than realising gains during your lifetime.
“Again, this could feature in any review of death taxes. Some have called for reforms to end to the exemption on death – arguing that the current system actually discourages productive investment. Both the Institute for Fiscal Studies and the now-disbanded Office for Tax Simplification have called for reforms to treat recipients of inherited assets as though they’d acquired the asset at the original base cost, removing CGT uplift.
“Lastly, trusts can be a key tool used in the IHT planning process and are subject to their own set of rules and tax rates. These could also fall within the scope of a review of death taxes, and would add another layer of complexity to any changes at the Budget.
“All of this illustrates that, while simply increasing the rate of IHT or reducing reliefs could be options, they may also come with a host of other complex rules and reforms. For anyone looking at estate planning and trying to work out how these rules may impact them, it’s well worth considering speaking to an adviser given the complexity in this area and the huge range of tax planning tools that can be used.”
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