Inheritance tax (IHT) rates and thresholds have been frozen for more than a decade, with no sign of this changing until at least 2028. Rising house prices and investment growth mean that even families with a relatively modest level of wealth could be affected.
But IHT rules offer several opportunities for planning. If you give away (or spend) enough assets during your lifetime, it is possible to avoid IHT altogether.
Of course, this must be balanced with your own needs, particularly if care costs become a factor as you get older. Deathbed gifts are not effective for IHT planning (except to bring your estate under the threshold for the residence nil rate band – see below for more on this) as you need to survive for at least seven years after making the gift for it to be excluded from your estate calculation.
So how does the seven-year rule work, and how can you use it to your advantage?
A Brief Guide to Inheritance Tax
The basic principles behind IHT are as follows:
- Everyone has a nil rate band of £325,000. If your estate is valued at under the nil rate band on death, no IHT will be payable.
- Transfers between spouses are exempt from IHT. No IHT applies on first death, and the surviving spouse can make use of both nil rate bands, up to a total of £650,000.
- Additionally, if the main residence is passed on to direct descendants, it may be possible to claim the residence nil rate band. This is up to £175,000 per individual (£350,000 for a couple), although it is reduced, and eventually revoked, for estates valued at over £2 million.
- Generally, if you have made gifts during the seven years prior to death, these are added back into your estate. There are some exceptions, which are explained below.
- The value of your estate which is not covered by the nil rate band, reliefs, or exemptions, is taxed at 40%.
Gifts that Are Immediately Exempt
Some gifts are immediately outside your estate and are not factored into the seven year rule. These are:
- Gifts between spouses (although these would form part of the joint estate on second death).
- Small gifts of up to £250 per person.
- Gifts of £3,000 in total per tax year. This exemption can be carried forward by up to one tax year if it has not been used. This means a couple, having made no prior gifts, could benefit from a total exemption of £12,000.
- Certain gifts in recognition of Christmas, birthdays, and weddings.
- Regular gifts from genuine surplus income. This means the gift must be affordable from earnings, pension income, property rental or dividends after your essential expenditure is covered. Regular gifts from capital do not qualify for this exemption.
- Gifts to charity or for national benefit.
Any gifts which do not fall into these exemptions will trigger the seven-year rule.
Potentially Exempt Transfers
A gift to an individual or a bare trust (which designates trust funds to one or more beneficiaries in fixed proportions) is a Potentially Exempt Transfer (PET) if it does not qualify for any of the exemptions above.
This means that the value of the gift will remain in your estate for seven years, and be factored into your estate calculation if you die within that period.
You can use annual gifting exemptions to reduce the value of the PET. For example, if a couple gifted £100,000 and had not made any previous gifts, they could use two years’ gifting exemptions (£12,000), leaving a PET of £88,000.
PETs use up the nil rate band first, so if either spouse were to die within seven years, their remaining nil rate band would be £281,000 (or £562,000 if they both died).
Chargeable Lifetime Transfers
A Chargeable Lifetime Transfer (CLT) is a gift to a discretionary trust. Gifts to companies can also be considered CLTs, however this is a complex area of business planning.
If the gift is under £325,000, no tax applies when the gift is made. However, if it is over this amount, a tax bill of 20% of the value over the nil rate band can be expected. If the ‘settlor’ (the person making the gift) dies within seven years, a further tax charge of 20% is applied, taking the total IHT liability to 40%.
After seven years, not only is the gift outside your estate, but it is also outside the estate of any beneficiaries. Trusts can be a useful way of reducing your IHT liability while keeping some control over the money. However, there can be significant tax implications, so it is worth seeking advice.
If you have made a gift that exceeds £325,000, the excess will be tapered, so that a reduced tax bill applies if you die after three years. The tax charge starts to reduce by 8% per year from year 4 (to 32%) to nil after year 7.
If you wish to mitigate IHT completely, you can potentially look at taking out an insurance policy that covers any residual IHT if you die within seven years.
|Years between gift and death
|Less than 3 years
|3 to 4 years
|4 to 5 years
|5 to 6 years
|6 to 7 years
|7 or more years
Making a Second Gift Within 7 Years
If you make a second PET within seven years, the total value of the gifts is added back into your estate if you die within seven years of the last gift.
This means that theoretically, a gift could remain in your estate for up to fourteen years.
It is always worth thinking carefully, and taking advice, if you are considering making successive gifts.
Options for Reducing IHT
As well as making gifts, there are some other options for reducing or mitigating your IHT liability. For example:
- Investing in assets which qualify for business relief. This can include the shares of your own company as well as other smaller business, or shares listed on the Alternative Investment Market (AIM). (Please note that AIM listed shares are high risk and can fluctuate widely in value.)
- Take out whole of life insurance to cover your IHT liability on death. If the plan is placed in trust, the cover can be paid out without increasing the value of your estate.
- Pensions are outside your estate for IHT purposes and can be paid out to your beneficiaries free of tax if you die before age 75. After age 75, your beneficiaries would simply pay tax on any withdrawals at their marginal rate. It can be efficient to preserve, and even top up your pension, running down your other, less tax efficient assets first.
- While deathbed gifts will be added back into your estate for IHT purposes, they could bring your estate under the £2 million threshold to qualify for the residence nil rate band. This could potentially reduce your joint IHT bill.
While gifts can be a great way of reducing your IHT liability, it’s important to secure your own financial position first. A financial planner can help you decide how much to gift and when, or if another option would be more suitable.
Please do not hesitate to contact a member of the team to find out more about estate planning.
The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested.
The Financial Conduct Authority does not regulate trusts, tax or estate planning
The content in this article was correct on 18/12/2023.
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