Wondering how to save on inheritance tax?
- TBA
- Jul 19, 2024
- 5 min read
If you inherit an estate from family or relatives, you are required to pay inheritance tax to HMRC.
Don’t underestimate this tax as it can be quite substantial—up to 40% of the estate’s value, potentially amounting to hundreds of thousands of pounds!
After a lifetime of hard work accumulating significant assets or property to provide a comfortable life for our loved ones, no one wants their heirs to lose a large chunk of that inheritance to unnecessary taxes.
Did you know that there are actually many ways to plan for this tax bill? The earlier you are aware, the sooner you can prepare and plan the distribution of your estate to avoid or reduce unnecessary inheritance tax.
Today, we will summarise several key tax-saving strategies to help you plan your inheritance tax bill effectively.
1. What is Inheritance Tax?
In the UK, when your children or any other relatives to inherit your assets—such as property, money, or other possessions—after your death, they will need to pay inheritance tax.
Under current rules (as of 2024/25), the inheritance tax rate is 40% of the estate’s value.
Like other taxes, there is a personal allowance. In the 2023-24 tax year, each individual has a tax-free threshold of £325,000—referred to as the nil-rate band. This threshold has remained unchanged since 2010-11 and will be frozen until April 2028. This means HMRC will only tax your estate on the value exceeding £325,000.
For example, if you leave an estate worth £500,000, the tax would be £70,000 (40% of the £175,000 difference between £500,000 and £325,000).
2. Who Pays Inheritance Tax?
Usually, the person inheriting the estate is responsible for paying the inheritance tax. For instance, if you leave all your assets to your children, they will need to pay HMRC.
HMRC requires the tax to be paid by the end of the sixth month after the person’s death.
Inheritors need to apply for an inheritance tax reference number at least three weeks before making the payment. Generally, your estate consists of everything you own, minus debts (like a mortgage) and expenses (such as funeral costs). The inheritors will use funds from the estate to pay this tax.
3. Nine ways to reduce inheritance tax
Gifts
One of the simplest ways to avoid inheritance tax is to give your money away.
UK tax law allows you to give away up to £3,000 worth of gifts each tax year. You can carry over any unused allowance from the previous tax year but only to a maximum of one tax year. This means you can give away up to £6,000 each year (or £12,000 for married couples).
Small gifts: Each tax year, you can give away gifts worth up to £250 per person without using another tax exemption. Additionally, birthday or Christmas gifts from your income are exempt from inheritance tax
For weddings, gifts also have exemptions depending on your relationship with the bride and groom. For grandchildren or great-grandchildren, you can give up to £2,500 tax-free; for children, the exemption is £5,000; and for other individuals, it’s £1,000. Note that wedding gifts must be given before the wedding and the wedding must take place; otherwise, the gift will be classified as a potentially exempt transfer (PET).
HMRC also allows you to pay some living costs for others as ‘normal expenditure out of income’:
Paying rent for children
Paying into a savings account for children under 18
Providing financial support for elderly relatives
As long as the transfer qualifies as ‘normal expenditure out of income’, the amount gifted is tax-free with no limit, but you must be able to afford it after covering your own living expenses.
If you are gifting to the same person, you can combine ‘normal expenditure out of income’ with other exemptions. For example, you can regularly pay £60 a month to your child (£720 annually) and also use your annual £3,000 exemption in the same tax year.
Larger gifts can be classified as PETs, which become exempt from inheritance tax if you live for seven years after making the gift.
Children and/or grandchildren
If you leave your home to children or grandchildren (including adopted, fostered, and stepchildren), you can benefit from the residence nil-rate band (RNRB).
If the property value is below £2 million, the RNRB can increase the inheritance tax threshold to £500,000.
Only direct descendants are eligible; other relatives or friends do not qualify.
Spouse or civil partner
Leaving your entire estate to your spouse or civil partner means no inheritance tax is due.
Donating to charity
In the UK, any amount left to charity (as long as the charity is registered in the UK) is exempt from inheritance tax. This applies to donations to UK political parties or local sports clubs as well.
Moreover, if you leave over 10% of your taxable estate to a charity, the inheritance tax rate on the remaining estate drops from 40% to 36%.
The 10% threshold applies only to the portion of the estate over the tax-free threshold. For example, if your estate is worth £425,000, donating over £10,000 (10% of the amount above £325,000) allows you to benefit from the lower tax rate.
Purchasing life insurance
If reducing your inheritance tax bill is not possible, you can buy life insurance.
By writing the life insurance into a trust, the pay-out will not form part of your estate. If you pay the premiums yourself, HMRC will treat them as lifetime gifts. These premiums usually qualify for the annual £3,000 exemption or ‘normal expenditure out of income’ exemption.
Deed of variation
Your heirs can change your will after your death through a ‘deed of variation’.
For instance, if Mr. A’s father leaves him five properties, he can transfer three to others. This can reduce tax liability. The variation must be drafted within two years of death, and all affected beneficiaries must agree to the changes.
Using your pension
If you die before 75, most pensions are completely tax-free.
If you die later, the pension is taxed at the beneficiary’s marginal rate, which for most is 20%. It may be advantageous to rely on other assets for as long as possible and leave the tax-free pension to be used last.
Trusts
You can place assets in trust to remove them from your estate, reducing or eliminating inheritance tax liability.
Retirement interest-only mortgage
If you have a significant estate, a retirement interest-only mortgage allows you to release equity from your home and pass some of your estate to family early.
You pay interest monthly, with the principal repaid when you die or go into long-term care. Reducing the estate size early can lower or avoid inheritance tax, but you’ll need to consult a financial advisor to assess your specific situation.