How to avoid inheritance tax legally

No one wants loved ones to get lumped with a hefty inheritance tax bill unnecessarily.

Luckily there are many legal ways to dodge the dreaded 40 per cent ‘death tax’ if you want to pass on the maximum sum possible and are prepared to plan ahead.

But you shouldn’t lose sleep – let alone start working on elaborate avoidance tactics – unless you are certain you are rich enough for it to become a problem for your heirs. You still need to be comfortably off to worry about inheritance tax.

Just 5 per cent of people leave estates sufficiently large to make their beneficiaries liable for inheritance tax.

However, the property boom of recent decades means that figure is expected to rise to 10 per cent in years to come, with those inheriting in house price hotspots bearing the biggest financial burden.

Essentially, you need to be worth £325,000 if you are single, or £650,000 jointly if you are married or in a civil partnership, for your loved ones to have to stump up death duties. 

But there is a further chunky allowance – known as the residence nil rate band – which increases the threshold to a joint £1million if you have a partner, own a property, and intend to leave money to your direct descendants.  

Watch out though, once an estate reaches £2million this own home allowance starts being removed by £1 for every £2 above this threshold. It vanishes completely by £2.3million

If you are worth more than this, your heirs will have to hand over 40 per cent of your assets above those levels to the Government.

So, how do you reduce or avoid a large inheritance tax bill?

We have compiled a round-up of ways to do so, some of which can be undertaken easily by any ordinary person without the need for convoluted arrangements or to pay for professional help.

Others are complicated, risky, involve hassle and expense, or a combination of the above, and these more onerous options appear further down the list. 

1) Gifts: Hand over your money

You can gift £3,000 a year, plus make unlimited small gifts of £250, free from inheritance tax.

Married people and those in civil partnerships can give each other any sum they like free of tax, provided their partner lives in the UK.

Wedding gifts are also exempt, although the amount depends on how close you are to the bride or groom. The limits are up to £5,000 to a child, £2,500 to a grandchild or great-grandchild, and £1,000 to anyone else.

One less well-known type of unfettered gifting is to contribute to the living costs of someone else – younger or older relatives, for example – but only if you can prove it’s coming out of spare income.

Such gifts can be any size but must be made out of surplus funds, which means money that your heirs could show to HMRC via bank statements would otherwise have sat in your account doing nothing, explains Liz Alley, head of financial planning operations at Brewin Dolphin.

‘You hardly ever have to prove it but you need to be careful it’s demonstrable at some level. No jiggery pokery to make it look like you have a surplus,’ she says.

Beyond this, you can hand unlimited sums to other people if you want, but they will fall under the so-called seven-year rule.

Officially, these are called ‘potentially exempt transfer’ gifts, because if you survive seven years the money automatically becomes free of inheritance tax.

If you die before the seven years are up, inheritance tax is levied on a sliding scale – starting at the full whack of 40 per cent if it’s within the first three years.

The Government rules on inheritance tax and gifts are here, and see the table below.

 2) Trusts: Gifts with strings attached

With trusts, you are still giving money away and the seven year rule still applies, but you have more control than if you simply hand over your cash to someone else.

This is often a sensible way of passing on money to children or grandchildren, if you think they are too young to spend it wisely.

A very simple ‘bare trust’ or ‘absolute trust’ allows trustees you have appointed to keep control until beneficiaries are 18 – which might still seem too young especially if large sums are involved.

A ‘discretionary trust’ is more complicated but you can tailor the rules to suit the people involved and the circumstances.

However, trustees have to assess the holdings for inheritance tax every 10 years to satisfy HMRC rules, and tax could be levied both straight away and at a rate of 6 per cent in future.

So, you will need professional help from a financial planner or lawyer to set up a discretionary trust, and probably at intervals in the future too.

If you think you might need the money back at some point, you can set up a gift and loan trust. The trustees can invest the money outside of your estate for inheritance tax purposes, but you can opt to get it back.

The tapered inheritance tax if the person who sets up the trust – known as the ‘settlor’ – dies within seven years applies as shown in the gifting table above.

The Government rules on inheritance tax and trusts are here. An in-depth look at the different sorts of trusts and how they work can be found here. 

3) Life insurance: Put the policy in trust

Taking out life insurance can mean your loved ones get a payout straight after your death and free of inheritance tax – but you have to set it up correctly.

To stop a life policy payment getting rolled into your estate, and the taxman potentially grabbing 40 per cent of anything over your inheritance tax threshold, you need to put it into trust.

That allows you to appoint one or more beneficiaries of the trust, who will be paid the full sum due when you die, and without the delays involved with inheritance payouts.

You can insure your life for the sum you think your heirs will have to fork out in inheritance tax, to offset their liability.

Beware though that premiums can be high, especially as you get older, and if you cancel a policy you immediately lose all the benefits of taking it out in the first place.

You also need to be in good health, to avoid HMRC thinking you are just trying to dodge inheritance tax.

Putting a life policy into trust can be done with the help of a financial adviser, and you might well need legal input too.

4) Pension pots: Pass your retirement savings on to loved ones

The rules on inheriting retirement savings were relaxed in April 2015, but how much your heirs benefit depends on what type of pension you have and your age when you die.

The main change was the abolition of a hated 55 per cent death tax on pension income drawdown plans left to relatives.

Instead, beneficiaries now either pay no tax if the pension holder dies before age 75, or their normal income tax rate – with the money they receive added to their earnings to calculate this – if they are 75 or over.

Also, husbands and wives whose partners die before reaching 75 can now get annuity income from their spouse’s pension tax-free.

Previously beneficiaries of ‘joint life’ annuities or other types that come with death benefits paid income tax on what they received.

However, the changes have not affected people in final salary pensions – generally considered the best and most generous schemes.

This has tempted some savers to transfer out to less safe self-invested personal pensions or defined contribution schemes, or to income drawdown schemes if they are at retirement age, in order to leave money to their families.

That’s a big and irreversible decision though, since it means giving up a guaranteed income from retirement until you die, and shouldering all future investment and inflation risks to your nest egg on your own. 

Also, savers should beware that HMRC might look askance if you transfer out of a final salary pension while in poor health and die within two years. HMRC could decide to include it in your estate for inheritance tax purposes anyway.

‘With pensions, you have to be careful if you do things like this when you think you’re within two years of death. It may still make sense overall, but there is a potential inheritance tax implication to consider’, says Ian Dyall, head of estate planning at Tilney.

‘For example, if the defined scheme has no widow’s benefits then even with the tax bill the spouse will get more than she would if the money stayed in that scheme.’ 

5) Supporting a cause: Give to charities and political parties

You can gift or bequeath money to charities and political parties and it will be excluded from your estate when inheritance tax is calculated.

A political party has to have succeeded in getting at least one MP elected to parliament to qualify for this exemption.

There is also a way to reduce your heirs’ inheritance tax rate from 40 per cent to 36 per cent of your taxable estate by giving to charity – although not to a political party.

You can do this by bequeathing at least 10 per cent of your net estate – the part liable for inheritance tax – to charity in your will.

6) Property handover: Give your home to your kids and pay them rent

Keeping your home in the family and out of the taxman’s clutches sounds like an attractive proposition, but there are pitfalls to gifting a property to your children before you die.

Liz Alley of Brewin Dolphin explains: ‘If you genuinely sell your house for the correct market value, live in it and pay the correct market rent, you are okay.

‘If you give away your house and pay a little bit of rent, that’s a “gift with reservation”. HMRC pulls it back up to 100 per cent when calculating your inheritance bill.’

Alley also notes that even if you do sell your house to a child for the right market value and they charge you full rent, the money they get from you will count towards their income tax bill, potentially pushing them into a higher tax bracket.

Meanwhile, if your child becomes a buy-to-let landlord in this way, that comes with a host of other rules and tax liabilities that apply even if a family member is their tenant.  

7) Home ownership: Switch from being ‘joint tenants’ to ‘tenants in common’

Most people who own property together do so as joint tenants. That means they ‘jointly and severally’ own 100 per cent of the home, and when one dies the other becomes the 100 per cent owner, says Liz Alley of Brewin Dolphin.

‘This overrides anything you may say in your will, so you cannot leave your share of the property to anyone else,’ she says.

Spouses don’t pay inheritance tax so there is no liability at that stage if they get the home after the death of a first partner – although if the co-owner is anyone else it could be due, subject to the usual thresholds.

But if a couple opts to make their ownership ‘tenants in common’, they have the option of splitting it differently – say, 40/60 – and leaving their share to someone other than their partner, says Alley.

You may not want your partner to inherit your share of the property, because this could increase the value of their estate so that when they die their heirs have to pay inheritance tax, she explains.

‘Before the second death, some value is already out of the estate. So if it was 50/50, and 50 per cent went to a son, it would now be out of inheritance tax,’ she adds.

‘If you and your partner have children, you could leave your share of the property to your children so that when your partner dies only his/her share of the house is counted as part of his/her estate.’

Alley says you should see a solicitor if you are considering this one.

If you are currently joint tenants in a property, you can choose to switch to tenants in common if you prefer, and this can still be done even after one partner has died, says Ian Dyall of Tilney. The Government explains the rules here. 

8) Owning a business: Pass on the family firm

To prevent inheritance tax bills capsizing or forcing sales of small firms, the Government offers protections when trading businesses are left to family members.

To qualify for business property relief, you need to have owned a firm or shares in it for at least two years by the time you die.

Privately owned firms and some listed on AIM, the small company arm of the London Stock Exchange, qualify for BPR.

But there are exceptions, such as those in the property or investment sector. There are also separate rules for businesses involving farming and forestry, which we look at in more detail below.

9) Boosting enterprise: Invest in small companies

To encourage investment in smaller business ventures, the Government also gives people protection from inheritance tax if they hold shares in firms with BPR status for at least two years.

Some specialist investment firms offer schemes helping people buy shares in the right companies to cut their inheritance bill. Providers such as Octopus, Canaccord Genuity and Downing run AIM Isas with this purpose in mind.

However, investors interested in this area should beware that firms qualifying for BPR are at the adventurous and therefore riskiest end of the spectrum.

You need to research carefully, and spread your investments so they are not too concentrated in this area and not sufficiently exposed to other assets like large company shares, commercial property, or corporate and government bonds.

This makes BPR a suitable inheritance planning tool for wealthy people, who are either experienced investors themselves or can afford high end financial advice, not the modestly well-off who can’t afford to risk a lot of their investment pot in this sector.

In this vein, a joint investment and insurance deal was launched a few years ago offering wealthy savers instant protection against inheritance tax, rather than having to wait two years.

The Foresight Accelerated Inheritance Tax Solution works by offering access to investments that qualify for Business Property Relief after you’ve held them for two years, alongside an insurance policy that would cover a 40 per cent inheritance tax bill on them if you died in that initial period. 

When the Foresight product was launched, Ian Dyall of Tilney said innovative products were always welcome in the industry because they offer clients more options.

But he cautioned that with BPR products, people will be investing in small companies so it’s important to consider how suitable that is and ‘look more holistically’ at their whole situation.

Dyall warned investors against getting blinded by the tax savings and putting money in products they would otherwise steer clear of, suggesting they consider both the increased risk of investing in small companies and the liquidity of an investment in terms of how accessible the money will be to the next generation if they need it.

10) Farming and forestry: Arcane corner of tax law

‘If you are not in the business, these are the least practical and most complex to get your head round,’ cautions Liz Alley of Brewin Dolphin.

Even if you are a farmer or landowner, this is the kind of specialist area where you will need professional advice on inheritance planning.

You are allowed to pass on property free of inheritance tax if it qualifies for agricultural relief, which is described by the Government as ‘land or pasture that is used to grow crops or to rear animals intensively’.

But there are strict rules about what is and is not covered – farmhouses are included but farm machinery, livestock and harvested crops are not, for example.

And to qualify, the property must have been held and occupied for at least two years by the owner or their spouse, or seven years by someone else, and be part of a working farm in the UK or European Economic Area.

Meanwhile, people who own woodland can get full BPR from inheritance tax if it has been owned for two years and is commercially managed.

They can also qualify for woodland relief, which defers inheritance tax – perhaps indefinitely – on the value of growing timber until it is felled and sold.

The inheritance tax rules for farmed land are here. The Government advises people to contact the inheritance tax and probate helpline if their estate includes a farm or woodland.