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How to avoid inheritance tax (IHT)

Updated 08 December 2022

4min read

Steve Johnson

‘One day, son, sixty per cent of this will be yours…’ Is inheritance tax the most unpopular tax of all? IFA Steve Johnson offers his tips on how to avoid inheritance tax (IHT) for those who feel they have already been ‘taxed to death’.

Your family and inheritance tax

Inheritance tax (IHT) is one of the more punitive taxes, weighing in at a hefty 40 per cent (more than twice the rate of basic income tax). The taxman’s logic seemed to be that he might as well go for it, since people would be too dead to object. He seems to have forgotten about the relatives, but then you can’t plan for everything.

Having scored ‘nil points’ in the popularity contest, IHT tries to make up for it with a nil-rate band (NRB) that allows the first £325,000 of a person’s estate to be inherited tax-free. Furthermore, since that amount is roughly equal to a broom cupboard in Greater London, this was recently followed by the main residence nil-rate band (MRNRB) that grants an additional tax-free £150,000 for one’s primary home, rising to £175,000 in the 2020/21 tax year. The problem of course is that property prices continue to rise, most taxes increase the better off you are, and at the higher end you start to lose some allowances (GRRRR).

The upshot is that a tax originally designed for the super-wealthy is now a weapon of mass taxation (WMT oh all right I’ll stop with the acronyms). It’s also something of a postcode lottery, given how wildly property prices can vary up and down the country. So the question on many people’s lips is: how can I pay less inheritance tax?

How can I pay less inheritance tax?

Broadly speaking, there are seven strategies for reducing or avoiding your inheritance tax (IHT) liability – six of which I might recommend to my clients (with the seventh, you’re on your own). Here’s a quick frolic through those options.

1. Gift allowances

You can make gifts of £3,000 per year (two lots the first time) out of your saved assets. Bear in mind, however, that you can also gift much higher regular amounts out of your normal income, providing that you can demonstrate that you can afford to do so. This sometimes allows significant amounts to be gifted. Needless to say, strict record-keeping is a must so you can keep track of all these gifts, while proving that those gifts from your income are affordable.

2. Give some or all of your money away

You can make larger gifts of money, provided that you then manage to stay alive for the next seven years (not always easy to do, especially if you’re reading articles about tax). These are called potentially exempt transfers (PETs) – and yes, a PET is not just for Christmas, it’s for seven of them. Apparently there are plans to reduce this period to five years, but that could be… years away.

The good news is, there’s no limit to the size of this kind of gift. The problem here are the four Ds: debt, divorce, debility and death. Essentially, if during this period your beneficiary dies, gets into debt, divorces or suffers debility (i.e. illness, particularly mental illness), then any of these could be bad for effectiveness of your gift.

3. Life insurance

Life insurance can be an effective way to cover an IHT bill, provided you are in good health when you set it up. You take out cover and place it under trust (so that the pay-out falls outside of your estate) and on your death it clears any IHT bill without exacerbating the tax situation. You must pay the premiums on the policy out of your normal income (see point 1).

4. Use your pension freedom

Pension freedom has been with us since 2015, but still not enough people are using it to its full extent. If you have a private pension fund, this method can work really well. You do your best not to spend all your pension fund before you die (e.g. by living off your other assets as far as possible), and then when you die, any unspent fund will pass tax-free to your kids or grandkids etc. (provided you have set things up properly). Money can therefore cascade down the generations. Remember though: you don’t use your will to do this! Pensions don’t form part of your normal estate, so you need to make your wishes clear with each pension provider.

5. Make charitable donations

Making gifts to charity will reduce the size of your taxable estate (obviously) – but even better, it can reduce the overall rate at which you pay IHT (from 40 per cent to 36 per cent). Bear in mind that to achieve this you’ll have to give at least 10 per cent of your net estate to charity.

6. Move abroad

Leaving the UK can work to reduce IHT – but beware of leaping out of the frying pan and into the fire. You’ll also need to be careful about visiting the UK or keeping property here, as HMRC may consider that you’re still resident and/or domiciled in the UK.

7. ‘Fancy stuff’

Here at S Johnson Wealth Management LLP we do not get involved in fancy stuff, since it often attracts HMRC interest. We prefer to leave it to those much cleverer / stupider than us (delete as you see fit).

Conclusion – and the small print

In summary, then, your options to avoid inheritance tax are: spend it, gift it, stick it in your pension, send it to charities, set up insurance and trusts, or emigrate – or else, die and get taxed.

As you can probably tell, the above is written with a conscious effort to combat narcolepsy. This means it’s only a quickfire summary of what can be complex situations full of caveats, traps and pitfalls. Therefore, if any of this might apply to you, you should really consider paying someone like us (or even us) for advice in this area. Especially if you might be losing a lot more to the taxman otherwise…

If you found this article helpful, you might also find our article on inheritance tax business property relief informative too.

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About the author
Steve Johnson
Steve Johnson is an independent financial adviser based in Birmingham.