How can I reduce my inheritance tax bill?

Tom Kieldsen


4 min read

Inheritance tax is charged at 40% and applies to nearly all types of property, possessions, savings and investments on the owner’s death. By making the most of your tax-free allowances, and with other measures such as giving gifts, you can lower your bill.

Leave less than the inheritance tax threshold? You’re clear

There is a tax-free threshold on inheritance tax called the “nil rate band”. It currently means the first £325,000 of an individual’s estate is free of inheritance tax.

Let’s say someone who is neither married nor in a civil partnership leaves an estate worth £1 million. Inheritance tax is only payable on £675,000 of the value of the estate. At the 40% rate, this means the tax bill would be £270,000.

When it comes to tax, it pays to have a partner

If you leave your estate to your spouse or civil partner, there is no inheritance tax to pay1. But not only that – your nil rate band is also transferred to the surviving partner. That means that if you are the sole beneficiary of your spouse or civil partner’s estate, you can in turn pass on the combined estate with a nil rate band of £650,000 when you die.

To continue the earlier example, a £1 million estate of a surviving spouse or civil partner would, on the survivor’s death, be subject to tax on £350,000 of the estate. At the 40% tax rate, the bill would be £140,000.

A main home benefits from additional tax-free allowances

As of 2017, there are further benefits for homeowners. If you pass on your main home to a direct descendant (children, foster children, step-children or grandchildren), then as of the tax year 2019-2020, you can add an extra £150,000 on top of your nil rate band2.

That brings the tax-free allowance for qualifying estates up to £475,000. Spouses or civil partners who share their allowances can therefore potentially leave an estate worth up to £950,000 tax free.

The benefits of the residence nil-rate band are tapered for estates worth more than £2 million. As of the tax year 2019-2020, the additional allowance is withdrawn entirely for estates worth £2.3 million or more3.

Inheritance tax treatment for other types of investment

How are other types of investment treated under inheritance tax laws?

ISAs – Although income and capital gains tax efficient, ISAs remain liable to inheritance tax.

Pensions – These are not usually subject to inheritance tax. For some, they can prove a valuable way of mitigating the inheritance tax payable by the estate. The way in which pensions are treated is a little complex, however, and those inheriting a pension may have to pay income tax should they withdraw from it.

Capital gains – Although the full value of assets, including gains, will be assessed for inheritance tax purposes on death of the owner, any unrealised capital gains will not also be subject to capital gains tax.

Ownership of a business – Inheritance tax on a business may be reduced by up to 100% depending on the nature of the business and the way in which it is owned.

 

The joy of giving is greater than receiving

Another way to reduce your inheritance tax bill is to give money away before you die. However, there are clear rules about what is acceptable for tax purposes. Everyone can give away up to £3,000 a year exempt from inheritance tax. Wedding or civil ceremony gifts may be exempt depending on their value and who they’re for (if it’s for a child, you can give up to £5,000 free of inheritance tax)4.

Another method is to make a regular gift from excess income. This is an underused but potentially valuable method of gifting; however, to avoid falling foul of the law it may be worth consulting an adviser before setting up this kind of gift.

The rules on gifts are strict. You cannot get around inheritance tax by transferring the ownership of your home to a son or daughter and living there rent-free. Nor would it be acceptable to sell your property to your children for less than its market value.

The general rule is that gifts only become fully exempt from inheritance tax after seven years, although the rate of tax starts to reduce after three years.

More methods of reducing inheritance tax

What about trusts? For some people, often high-net-worth individuals, trusts can be a useful tool in managing tax and the distribution of assets. However, in recent years many of the historic tax benefits have been reduced or removed.

Another option is to take out a life assurance policy. When you die, the payout from the policy will help to settle your inheritance tax bill. These policies are often expensive but can be effective in reducing the tax liability without giving assets away.

Who pays inheritance tax and at what stage?

Inheritance tax is usually paid from the estate of the deceased, before the remainder is distributed and probate completed (probate is the legal process of dealing with the estate). Assuming there is a will, usually a family member or trusted friend is named as executor. This is the person responsible for administering the estate and making the inheritance tax payment. Executors often seek legal and tax advice, which is usually paid for by the estate.

 

Sources

  1. You can also leave your estate to a charity or “a community amateur sports club” tax free. https://www.gov.uk/inheritance-tax
  2. The residence nil-rate band will rise to £175,000 in the tax year ending 2021 (and increase in line with the consumer price index after that). https://www.gov.uk/guidance/inheritance-tax-residence-nil-rate-band
  3. See ‘Tapering away the RNRB’ section here: https://www.gov.uk/guidance/inheritance-tax-residence-nil-rate-band
  4. https://www.gov.uk/inheritance-tax/gifts

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Tax treatment depends on your individual circumstances and may be subject to change in the future. This is a general overview of inheritance tax and is not financial advice, if you need tax advice please speak to a financial adviser.

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Tom Kieldsen

Tom is a financial adviser at Nutmeg. He joined in April 2018, following more than 11 years with a leading private bank. Outside of work, he enjoys exploring his local countryside and cooking – preferably BBQ.


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