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It’s a trap! Navigating the UK’s most hated tax

July 4, 2023

UK inheritance tax is set for record receipts this year, with early forecasts predicting the total figure to hit £7.7bn in the 2023/24 tax year1. 

With the topical news that inheritance tax (IHT) is set to redirect more money than ever to HMRC this year, I discuss some of the most effective ways of minimising your IHT liability via an intergenerational approach, so that your family and loved ones are looked after long before your time comes. 

 What is Inheritance tax? 

IHT is a tax on the estate of a deceased individual who has left assets valued above their tax-free threshold. This is usually charged at a rate of 40% for the excess on any asset value above their threshold. An individual’s tax-free threshold for the current tax-year is £325,000 (known as the nil-rate band), which was frozen by the Chancellor until 2028 during the 2022 Autumn Statement. This threshold is also extended by a further £175,000 (known as the residence nil-rate band) if an individual elects to pass on their main residence to a direct descendant (including adopted and stepchildren). This is providing that their estate is valued at up to £2 million, while for estates valued over £2 million, the residence nil-rate band is tapered down by £1 for every £2 over £2,000,000. For spouses and registered civil partners, both the Nil Rate Band and the Residence Nil Rate Band can be inherited by the surviving spouse after first death, so that there is no IHT liability until both partners are deceased. 

Pensions 

Following the 2023 Spring budget, pensions have now become a particularly paramount element of financial planning with regards to mitigating IHT. The budget brought a fundamental overhaul of pension legislation, primarily by abolishing the Lifetime Allowance which has been in place since 2006, and by increasing the Annual Allowance. The Lifetime Allowance was the total amount you could build up in your pension savings before incurring a tax charge when you make a withdrawal or take an income from this wrapper. This allowance was set at £1,073,100 – meaning any value over this faced an additional tax charge of either 55% if taken as a lump sum, or 25% if taken to set up regular income. The Annual Allowance on the other hand, is the total amount an individual could deposit into their pensions in any given tax year. Currently, this is the lower of £60,000 or 100% of gross taxable earnings in a tax year, which is a significant increase from the £40,000 allowance that was set prior to the budget. 

Pensions fall outside of an individual’s estate for IHT purposes, meaning any value accrued at the date of death, will not be subject to inheritance tax. The legislative changes brought by the Spring budget therefore make pensions considerably more attractive for inheritance tax mitigation. 

Maximising utility of Nil rate bands 

Perhaps the biggest selling point of setting up a will, is that they enable you to maximise the utility of your nil rate bands. A recent study conducted by Canada Life in 2023 found that half of UK adults still do not have a will2 

Your nil rate band is essentially the amount you can pass on to your beneficiaries completely free of inheritance tax. This is currently set at £325,000 which can be set against all assets, plus £175,000 to those who are passing on a qualifying main residence to their direct descendants. However, when an individual dies without a will, their partner retains any assets up to a value of £270,000, while anything above this is split 50:50 between the partner and the deceased’s children. If the amount received by the surviving spouse and children exceeds the nil rate bands mentioned above, they may have a hefty IHT bill to pay, which could have been avoided by deferring this liability until after the death of the second spouse, and thereby using both of their nil rate bands combined as there is no IHT liability when assets are inherited by a spouse. 

Giving assets away 

An individual in the UK can give away £3,000 each year tax-free with one year’s carry forward (so £6,000 in the current tax year provided no gifts were made in 2022/23). In addition to this, any gifts made by an individual that exceed this allowance would qualify as ‘Potentially Exempt Transfers’ (PETs) provided they are a gift to another individual or to a specified trust. PETs are only chargeable if the individual who made the transfer passes away within seven years of doing so. If this is the case, PETs still benefit from taper relief once the transferor has survived three years, if the value of the PET exceeds the individual’s nil-rate band- if it does not exceed this, it simply uses up part of the Nil-Rate Band first. This not only means that the recipient pays less IHT had the gift simply been left in a will, but they also receive the gift without having to await the often-lengthy process of probate during an already difficult time. 

In addition, any gifts made from surplus income are wholly exempt from Inheritance Tax. For the majority, gifting out of surplus income becomes trickier in later life as income tends to reduce post-retirement, so it is never too early to plan ahead and ensure your loved ones are the sole beneficiaries of your assets. 

EIS/SEIS/AIM 

Enterprise Investment Schemes (EIS) and Seed Enterprise Investment Schemes (SEIS) are venture capital schemes which offer tax incentives for individuals who want to invest in companies that are not listed on any recognised stock exchanges. These are small companies which have been trading for less than seven years and have gross assets of less than £15m at the time of share issue. Similarly, Alternative Investment Market (AIM) shares are IHT-free once they’ve been held for over two years. AIM is a sub-market of the London Stock Exchange where smaller companies gain access to public markets in much the same way as larger public companies enjoy. 

Investments in qualifying EIS, SEIS, and AIM companies benefit from 100% inheritance tax relief, assuming the investments have been held for at least two years and at the time of death of the investor, as they benefit from Business Protection Relief. However, as these investments target young start-up and scale-up companies, they pose a much higher investment risk than alternative mainstream investments such as funds or bonds. 

Trusts 

Trusts are a useful way of managing your assets during your lifetime, and your estate once you have passed away. Assets transferred into a trust are, in effect, outside of your estate and excluded from your Inheritance Tax calculations. However, this does not mean that trusts are always completely free of IHT, as a 20% charge is generally due when trusts are set up with assets that exceed the nil-rate band (£325,000), or the full 40% if you die within 7 years of making a transfer into a trust. Some of the most common trusts are listed below: 

Discretionary Trusts – Grants trustees flexibility over how to use the trust assets for the benefit of the chosen beneficiaries. This is ideal for those with grandchildren or young and even unborn children for whom they are keen to provide for. 

Bare Trusts – This trust simply holds the assets and the income provided by such assets for the intended beneficiaries until they are 18 years of age (16 in Scotland).  

Interest in Possession Trusts – Where the income created by the assets in the trust are passed on to any income beneficiaries as the income arises. The assets themselves are then passed on after the death of the income beneficiary, as they are only entitled to the income and not the assets themselves. 

Although Inheritance tax has at times been considered a tax on the wealthy, the number of individuals that are falling into the taxable threshold has doubled since 2018-19, and with nil-rate bands frozen until 2028 despite historic levels of inflationary growth and rising house prices, this is a trend that shows no end in sight. However, with careful financial planning, this is a tax that can be limited or avoided entirely. 

If you’d like to find out more, please get in touch with our Financial Planning expert, Matheus Talbert, at matheus.talbert@hentons.com.

 

Gary Olding

Gary is the National Head of Tax and overseas our Tax Compliance and Medical Tax Teams. When not dealing with clients he is supervising operations, troubleshooting, and optimising workflows.

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