Inheritance tax: How to increase tax-free threshold

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Inheritance tax (IHT) is applied to the estate, such as property, money, and possessions, of a person who’s died and can leave families with a sizeable bill to pay. However, if managed tactfully, there are ways people can boost the tax-free threshold and pass on a lot more to relatives and friends – so, it’ll pay to know more about the current legislation.

What is the current inheritance tax threshold and when is it applied?

Inheritance tax is charged on a person’s estate if the total value exceeds £325,000. This is the current tax-free threshold for the 2022-23 financial year.

The estate figure is confirmed after the value of the person’s assets (cash, property, personal possessions and investments) are added together.

If total assets exceed £325,000, a 40 percent tax will be applied to the rest of the estate. However, there are some ways to increase this threshold.

Simon Malkiel, Partner at law firm Howard Kennedy explained: “If you don’t entirely use that allowance, the remaining balance can be transferred to your surviving spouse or civil partner – potentially taking their allowance to £650,000.”

Mr Malkiel continued: “Your family home qualifies for a further discount if your total estate is under £2.35million, when there’s up to an additional £175,000 tax-free when passing on your house to your children or later grandchildren.”

In this instance, if eligible, passing on the house would bring the tax-free value to £500,000.

However, Mr Malkiel notes: “As before, any balance is also transferable to a surviving spouse if not used up on your death.”

With a high tax-free threshold, inheritance tax currently affects fewer than five percent of the UK population, although this may not be the case for long, according to Mr Malkiel.

He said: “As property prices and inflation rise, more and more are likely to be pulled into paying it. In fact, the Treasury has recently reported receiving an extra £700million over the last year – taking inheritance tax revenue to an all-time high.

“The average UK house is only £50,000 short of the threshold, and the Office for National Statistics doesn’t see this trend reversing. It predicts that by 2026-27, inheritance tax will raise £7.6billion a year.”

So now might be a good time to revisit how to reduce the burden – and avoid the pitfalls.

Make a will and Lasting Power of Attorney

Although many are unlikely to think about writing a will until later in life, Jeannie Boyle, director and chartered financial planner at EQ Investors, recommends making one sooner rather than later.

Ms Boyle said: “If you don’t make a will then your estate will be distributed according to the rules of intestacy.

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“Remember that these rules do not recognise unmarried partners. If you’re not married or in a civil partnership, then your partner won’t receive anything from your estate (that isn’t jointly owned by them) unless this is specified in your will.

“You should review your will if your circumstances have changed: for example, marriage can invalidate an earlier will.

“You can help your family by sharing your plans with them – you may even find that they suggest something different.”

Ms Boyle also suggests people simultaneously set up a Lasting Power of Attorney to ensure a trusted person can deal with their affairs if they lose capacity.

Make use of exemptions

There are several allowances for gifts which are automatically exempt from IHT, according to Ms Boyle.

These include:

  • £3,000 can be gifted every year. This allowance can be carried forward one tax year if unused.
  • Unlimited small gifts of £250 are also permitted
  • Gifts between spouses or for the maintenance of children, ex-spouses or dependent relatives are also exempt.
  • Gifts to people getting married are exempt: up to £5,000 for the person’s child, £2,500 for their grandchild or great-grandchild, and £1,000 for anyone else.

On gifts, Mr Malkiel elaborated that people can also: “Make outright gifts of any value tax-free, provided it’s at least seven years before your death.

“The rate starts to fall three years after the gift is made and drops gradually to zero over the following four.

“But watch out for the pitfalls – for instance, you can’t simply sign over a house and carry on living there. Your relatives could be stung for the full 40 percent tax bill if you do, potentially with other tax charges on top.”

Gift to a charity

Many people choose to make charitable gifts in their wills.

Ms Boyle said: “Although not always considered part of estate planning, such gifts can reduce the inheritance tax rate on death from 40 percent to 36 percent if used in the correct way.”

Maximise other reliefs

Stevie Heafford, partner at accountancy firm HW Fisher advised investing surplus cash in areas that qualify for relief, such as Business Relief or Agricultural Relief. 

She also suggests people draw down on cash reserves, such as ISAs, in preference to a pension, because pensions can be passed on IHT-free, while other investments can’t.

Ms Heafford said: “Whilst ISAs give the opportunity for tax-free growth and income, they still fall within the taxable estate on death and are subject to inheritance tax at that point.

“So if you have a pension pot but also other investments, it makes sense to utilise the other investments to defray expenses during your lifetime (or even to make lifetime gifts) and leave the pension to be passed on tax-free on death.”

However, she notes: “There can be other tax charges associated with passing on pensions depending on the type of pension it is, how you are paid the pension and the age of the person who has died.

“For example, if you receive a lump sum payment and the owner of the pension was under the age of 75 when they died, you will usually pay no tax.

“If you receive a lump sum but the owner of the pension was over 75 when they died, you will usually be subject to income tax which will be deducted by the provider.”

Ms Heafford added: “The key is, ‘It’s never too early to start planning’ but also, tax isn’t everything so make sure that you can still enjoy the lifestyle you want whilst you are still here.”

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