Avoiding Inheritance Tax

"The only certainties in life", said Benjamin Franklin, "are death and taxes." Ironic then that Inheritance Tax (IHT) clobbers you after you have died as well.

Well, it doesn't clobber everyone. The current IHT regime is quite lenient when compared to previous methods of calculating "Death Duties", or "Capital Transfer Tax", or whatever name it was known by. The top bracket was once 98% tax, you know. Seriously. No wonder there were so many tax exiles...

So what is IHT? Well, it's a tax that is paid on your estate after your death at a flat rate of 40%, subject to a few allowances and exemptions. Everyone, for instance, has a personal threshold (currently £285,000) which they are allowed to own prior to any tax being due. This threshold is very often referred to as the "nil-rate band", because everything within the threshold is taxable at a nil rate, i.e. zero. Over and above the threshold, tax is payable at 40%. So, to use a simple example, Mrs Bloggs has an estate of £300,000. The threshold is deducted, leaving £15,000, and IHT is due at a rate of 40% of that, so the tax due is £6,000.

This is a very simple example. Certain beneficiaries are exempt from paying tax, for example the surviving spouse and charities. So, if Mrs Bloggs left a husband, and he inherited her entire estate, then the tax payable would be nil, because there is no tax due on inter-spouse transfers, regardless of the amount. Similarly, if Mrs Bloggs left more than £15,000 (the amount in excess of the personal threshold) to charity in her Will, then there would also be no tax payable because bequests to charities are exempt from tax.

But hold on a minute. Let's go back to Mr Bloggs. Let's say that he has £300,000 in his own name as well. His wife dies and, for the sake of argument, he inherits her entire estate of £300,000, and pays no IHT due to the spouse exemption. His estate, however, is now worth £600,000! When he dies, only his personal threshold will be deducted (we'll assume it stays at £285,000) leaving a net estate of £315,000. This whole amount is now taxable at 40%, meaning a whopping tax bill of £126,000!

So what can be done to mitigate, or even avoid the IHT due?

Well, in the case of Mr and Mrs Bloggs, they could have had tax-efficient Wills prepared, meaning that at least they each utilised their own personal threshold. This simple task alone would have saved well over £100,000 in IHT.

They could have also given money away to their children, for example. If they had lived 7 years after making the gift, then it would be completely free of IHT. But they would have to give it away completely; if they made a gift but reserved the right to use the money later if they needed it, then that would be a "Gift with Reservation" and the Capital Taxes Office (CTO) would bring it into account.

There are various "schemes" being promoted by some firms that rely on using the matrimonial home in tax planning. It can work in certain circumstances but there is a feeling that the CTO are waiting to pounce on cases such as this, and it is generally felt that it is best to avoid using the home if at all possible when planning for IHT.

Insurance companies are keen to sell IHT policies, i.e. those that pay out lump sums to assist with any IHT burden. The premiums are generally very expensive though, and of course there are all those commissions to pay to the Wise. Not very Foolish. Far better to put that amount to one side in a separate account, or make a gift of it to someone. There is an annual gift exemption of £3,000 as well as £250 to any number of people per year, and over the course of time, that amount of money can be removed from someone's taxable estate without the need to comply with the "7-year rule".