Inheritance tax (IHT) is one of the most important considerations for anyone with a significant estate they wish to pass on.
But far from a rich person’s tax, every year more families are dragged into paying so-called ‘death duties’ thanks to rising asset prices, inflation and the harmful effect of fiscal drag.
Fiscal drag is a phenomenon that slowly drags more households into paying certain taxes. This works as asset prices, earnings and other sources of wealth grow over time, but the Government does not alter allowance levels – tipping these pots into tax liabilities.
IHT has one of the longest-run fiscal drag issues.
The basic threshold for IHT is £325,000. Estates below this threshold have no liability to pay IHT on death of the estate owner. But this threshold has not changed since April 2009 and is set to remain at its current level until April 2030 at the earliest.
In practice no Government has moved it. Over time this has tipped more and more estates into liability every year, with HMRC taking record levels of the tax every year.
The most recent take saw the Government earn £6.3 billion in the nine months to December 2024, an 11% increase on the same period in 2023.
Currently, according to Government figures, just 4% of estates are liable to IHT. But this is set to rise to 10% by 2030, thanks to fiscal drag. So, what can we do to protect our estates from IHT and the pernicious effects of fiscal drag?
Know the rules
Understanding the rules around IHT, the allowances, limits and timings is essential to ensuring an estate isn’t overwhelmed by the liabilities.
On top of the £325,000 nil-rate band is the residential nil-rate band. This is set at £175,000 and means this value is charged at 0% from your primary residence for IHT purposes.
Together with this, if you are married, there is no liability to pay IHT when one spouse inherits the entire estate from the other.
In practice this means two married partners can roll up their allowances to a level of £1 million in total to pass on tax-free to their families.
Gifting
Gifting is an important aspect of IHT and can be a good way to enable some tax-free transfers of wealth to loved ones.
You can make gifts – which include cash, personal goods such as furniture or jewellery, property or other assets. But a seven-year rule applies. These are called ‘potentially exempt transfers’ (PETs).
The seven-year rule stipulates that you can gift anything you like – of any value – but you must live for seven years after the gift in order to avoid incurring IHT liability.
The liability also reduces over time before the seven-year time limit. 0-3 years after the gift there is no tax reduction. 3-4 years it’s a 20% reduction; 4-5 years – 40%; 5-6 – 60%; and 6-7 years 80%.
Unfortunately, there is currently speculation that the Government could make the rule longer or even abolish the seven-year rule in order to squeeze more tax income out of liable estates.
Planning to make PETs can be an effective way to reduce IHT liability as any gift made reduces the overall size of an estate and therefore can bring it under the IHT overall thresholds.
However, it is a tricky plan to get right as considerations about age and lifestyle need to be made before gifts are handed out. An adviser can provide key assistance when making these plans.
Beyond PETs there are some key cash allowances that people can benefit from. This includes an annual £3,000 allowance for gifts which can be made to one person or split between more.
You can also make as many £250 small gifts as you like each year, as long as you haven’t used any other allowance on that person.
Parents and grandparents can make tax-free wedding gifts of £5,000 for a child, £2,500 for a grandchild or £1,000 for anyone else.
You can also make regular payments to others to help with things like living costs as long as you can afford the payments after meeting your monthly living costs, or if you pay out of your regular income.
Referred to as ‘normal expenditure out of income’ it can include helping to pay a child’s rent, paying into savings accounts for under 18s or giving financial support to elderly relatives.
Unfortunately, IHT is one of the most complicated aspects of managing a person’s wealth and finances. Anyone with IHT considerations for their own financial plans should seek financial advice in order to ensure that those who inherit don’t face high tax bills at a time of bereavement.