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Who pays inheritance tax and how to bring the cost down

Lana Clements
How much inheritance tax will you pay? Image: Fotolia

More and more Britons look set to be charged tax of 40% on assets passed on to friends and family when they die thanks to changes announced by the Government.

But who exactly will be affected and what can you do about it?

Growing problem

In 2009 just 12,000 families in the UK were forced to pay inheritance tax – the fewest since 1938 – but the tax’s net has been rising since then.

And now, to fund a cap on care home costs, the Government is to freeze the inheritance tax threshold at £325,000 until 2019 – three years longer than previously promised – and meaning this limit will not have changed for 10 years.

By keeping the limit static for so long, as house prices rise, more and more people are dragged into a tax charged at a painful 40%.

The threshold has been at the same level since the 2009/10 tax year, but if it had moved in line with Retail Prices Index (RPI) inflation, it would be set to increase to £358,000 in the coming tax year, according to Hargreaves Lansdown.

John Williams, managing partner at Kuber Ventures, said the move is “in effect, taking from the dead to help the dying”.

He added: “Thousands more people will now be caught by inheritance tax and must now find other means to limit the amount taken from their estate.”

How much is inheritance tax?

Currently up to £325,000 of inheritance can be passed on to others without being taxed. After the limit is passed, assets are taxed at 40%. On an estate of £500,000, this equates to a tax bill of £70,000.

Married couples and civil partners can combine both their inheritance tax thresholds so that double (£650,000) can be left to beneficiaries tax-free. A spouse’s threshold is automatically transferred when they die.

The tax is highly contentious, not least because it is taking money from assets that may well have already been subject to everyday taxes.

But as a good money spinner for the Government – approximately £2.7 billion was raised by the levy in the 2010/11 tax year – it’s not going anywhere.

However, there are ways to avoid handing over a chunk of your estate to the taxman before it reaches your family or designated inheritors.

How to reduce your inheritance tax bill

“Inheritance tax is probably one of the most disliked forms of taxation, but it is also one of the easiest to avoid,” said Danny Cox, head of advice at Hargreaves Lansdown.

The common route to limiting inheritance tax is by reducing the value of an estate before death. This usually is achieved by giving money away, known as gifting, as you get older.

However, it’s worth bearing in mind that any rights or say over “the gift” are given away at the same time.

Any gift, whether cash or asset, is free from inheritance tax if you live for at least seven years from the date of the gift. Of course, it is not always so easy to time the date of your death.  If you don’t live seven years after you have made gifts, the assets or cash are counted and use your tax-free allowance up to the threshold (£325,000) first.

Certain investments are exempt from inheritance tax after just two years, but as they are considered relatively high risk, they are not suited to everyone.

Alternatively, Hargreaves Lansdown said life insurance is inheritance tax planning’s “best kept secret”. Taking out a policy means your beneficiaries can use the payout to pay inheritance charges and receive the value of your estate in full. The policy must be written into trust so that payout is tax free.

If you don’t expect or are not sure if you will live seven years, money or assets can be given away subject to certain rules, as follows:

•    Give to your spouse - Married couples can transfer assets without limit between themselves without paying tax, either during their lifetime or at death.

•    Use annual allowance - A gift up to the value of £3,000 can be made to anyone of your choice without being subject to tax. Unused exemptions from the previous tax year can be carried forward to the present tax year – but no further.

•    Smaller gifts - As well as the annual allowance above, you can gift up to £250 to any number of people completely free of inheritance tax.

•    Give away your income - You can also give away as much of your income away as you please without paying tax.  Hargreaves Lansdown said this concession “is widely under-utilised, particularly by those with higher incomes”. If you are using this avenue, it must be a regular gift from post-tax income and leave you with enough money to maintain your standard of living.

•    Marriage gifts  - Parents and grandparents can make one off gifts (cash or assets) to children or grandchildren of up to £5,000 and £2,500 respectively tax-free when they get married.

•    Donations to charities or political parties - Any gifts to these types of organisation, either during your lifetime or through your will are exempt from inheritance tax.

Discretionary trusts

If you are not sure if you will live for seven years but don’t want your beneficiaries to have rights to your assets or money before you die, you can transfer them to a trust.

This allows the gift to be made and starts the seven-year clock ticking, but the gift is delayed until you decide.  For example, if the beneficiaries are still young and you don’t want them to receive the money just yet.