10 ways to minimise inheritance tax

Arguably the UK’s most hated tax, we outline 10 things you can do to reduce your inheritance tax (IHT) bill, including pension tips and AIM shares.

Inheritance tax (IHT) is a tax payable on the property, money and possessions – known as the ‘estate’ – of someone who has died. It has long been one of the UK”s most unpopular taxes – a 2015 YouGov poll found that 59% of people regard it as “unfair” – particularly because it’s a hefty 40% tax on already-taxed assets.

Ironically, considering the controversy it attracts, it’s a pretty insignificant tax in receipt terms. HMRC’s inheritance tax takings for 2020-21 were £5.4 billion, 4% up on the previous tax year.

For most people, the £325,000 IHT allowance or nil rate band (NRB) and £175,000 Residence NRB (which can be set against the value of the family home if it’s left to the children or grandkids), is enough to protect them from inheritance tax.

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In 2018-19 (the latest year for which these figures are available), only 22,100 estates - less than 4% of all UK deaths that tax year – faced an IHT charge. However, 2021’s Budget freeze on both allowances until 2026 is bound to mean those numbers rise over coming years.

If you’re worried that the value of your estate including your property might exceed the key thresholds, there are various steps you can take to reduce it and therefore the risk of a tax bill on your death. In the process, you may be able to make life better for your loved ones or other causes you care about. Remember, though, that the aim is not to leave yourself short of cash in the process, so don’t be a slave to IHT.

Be aware also that to make sensible estate planning decisions, you’ll need a clear idea of what your cash, investments, property and other possessions are actually worth. So that’s the place to start.

1) Understand the seven-year rule

It may seem pretty simple at face value just to give money or other assets away, if you can afford to do so, to reduce your estate. To that end, it’s worth working out how much you need to live on and cover any eventualities down the line, and making a plan for other assets that you won’t need.

If you make lifetime gifts and survive for seven years then those gifts aren't normally counted as part of your estate. But if you die within seven years then those gifts may become potentially taxable and you might not end up saving any tax. That's because the taxman will count the full lifetime gift as part of your taxable estate. The tax due on the gift may reduce if you die between three to seven years of making the gift.

For example, if a single person with an estate of £1 million gives £400,000 away and dies after five years, the recipient will owe tax when they die on £75,000 over the nil rate band (£325,000) – this tax amount tapers after three years. The nil rate band is used up and the estate owes IHT on the remaining £600,000. By contrast, if they give away only £200,000 and die after five years, the nil rate band reduces by £200,000 but there will be no taper relief as there is no tax due on the gift.

If you’re young, fit and healthy, the chances are that you’ll live many decades more and your generous gifts will fall out of your estate without a hitch. If you’re not so young, or are uncomfortable about the various risks entailed in giving large sums away, it’s well worth looking at the various exemptions and allowances below, and making the most of them.

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2) Make gifts to your spouse

There is no IHT payable on gifts between spouses, so you can give them whatever you like during your lifetime. There may, however, be capital gains tax to pay if you are transferring assets other than cash, such as property or shares, from one name to another.

Importantly, if you die before your spouse you can leave your entire estate to them free of IHT, and also your unused nil rate band and residence NRB, if you qualify for the latter. That means that on the second death, up to £1 million can be left to the family or other beneficiaries free of IHT.

Importantly, if you’re not married or in a civil partnership, there is no exemption and IHT is potentially payable if you leave assets to your partner. 

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3) Top up a pension

If you are still working and paying into a pension scheme, consider maximising your contributions. Quite apart from the many other tax benefits of paying into a pension, your pension scheme sits outside your estate and in most cases pension contributions are immediatelyfree of IHT (rather than being treated as PETs).

Importantly, your pension pot won’t be included in IHT assessments if you die. Indeed, once you retire, if you have sufficient other investments such as ISAs that do fall within your estate, you could fund your retirement with them and leave your pension untouched for your family to inherit.

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4) Use gift allowances

There are various gift exemptions and it’s well worth using them each year if you’re keen to reduce your estate. They include:

• £3,000 annual exemption, which can be given to a single recipient or split between as many people as you wish.
• Regular gifts out of income. This is one of the most useful allowances, as there is no limit to what you can give provided it’s made regularly out of your monthly income (rather than savings) and doesn’t affect your normal living expenses.
• Any number of small gifts of up to £250 per person each year, provided you have not given them gifts using another allowance.
• Wedding gifts of up to £5,000 per parent of the happy couple, £2,500 from each grandparent and £1,000 from anyone else.
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5) Top up someone else’s pension

It’s also possible to contribute to other people’s pensions. You could for instance pay up to £3,600 per year into a stakeholder pension for an adult child in work, and they would receive the pension tax relief as well as a very useful growing pension pot for later life.

That contribution would be outside your taxable estate, although it would not fall out of your estate for seven years unless it was covered by an IHT gift exemption such as the spouse exemption or the annual exemption.

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6) Make charitable gifts

Money that you give to charity is exempt from inheritance tax, whether you donate during your lifetime and subsequently die within the seven-year period, or arrange a legacy through your will.

Indeed, the government has incentivised charitable donations in wills: if at least 10% of the net estate is left to charity on your death, the rate of inheritance tax payable on the rest will be reduced from 40% to 36%.    

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7) Tap into business property relief

If you’re a business owner, you may qualify for inheritance tax relief on the value of your business assets - known as business property relief (BPR) – when you die, providing you have owned them for at least two years.

In some cases, the assets are entirely free from IHT, for example if you are a sole trader passing on the whole business, or a partner in a firm passing on your interest in it. In others, such as the transfer of the land or property used for your business, you’ll get 50% tax relief. Do take advice to ensure your business is tax-efficiently structured.

Other investments such as commercial forestry may also be entirely IHT-free, with no tax to pay on either the land or the value of the trees. But they have to be run as a business to qualify for BPR.

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8) Invest in AIM shares

Even if you’re not a business owner, you can benefit from BPR, because it also applies to unlisted shares. Most types of shares listed on AIM also qualify for full IHT relief, provided you’ve held them for two years (AIM is not deemed to be a recognised stock exchange and the shares are therefore considered unlisted as far as HMRC is concerned).

However, not all AIM shares work in this context; in general, for the shares to be eligible for BPR, AIM companies need to be actively trading and not investment or property businesses, but there is no specific list of qualifying companies, so check before you invest. Clearly, as well as potential IHT exemption, a well-chosen selection of AIM shares can also provide dividends and capital growth; but again, you do need to know what you’re buying.

If you would rather have a professional do the legwork for you than build your own portfolio, consider one of the readymade AIM IHT portfolios designed to be held in an ISA wrapper. Portfolio managers put them together and manage them, with leading names in the AIM IHT portfolio arena including Octopus, Invesco and Downing.

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9) Take out life insurance

It's possible to ease a likely IHT burden on your estate by taking out a whole-of-life insurance policy within a trust wrapper that keeps the whole thing outside the estate. The idea is not to reduce the amount of tax payable but to provide a lump sum to meet the bill.

Unlike conventional life insurance policies, whole-of-life policies have no set term and are designed to pay out on your death (provided you keep the premium payments up). Your beneficiaries can then use the money to cover the tax bill; ideally there’ll be some left over too.

Be warned, though, whole-of-life insurance premiums become dramatically more expensive the older/sicker you are, and the greater the sum insured. To give a rough example, for a single individual aged 60 requiring a £1 million payout on death,Edison Wealth Managementcites a current (February 2022) annual premium of £15,360 (no escalation, nil commission). For someone aged 70, that figure more than doubles to £32,280.

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10) Set up a gift and loan trust

There are various ways that you can use trusts in estate planning, particularly as a way of retaining some control over gifts you make to younger (and potentially feckless or vulnerable) recipients. A specialist financial adviser will be able to talk you through them. Remember, though, that trusts are legally complex and come with significant costs attached.

There are also trusts designed specifically to help you reduce your IHT bill.

One option, if you want to retain access to your capital but are happy to give away future growth in the investments, is to use a gift and loan trust. Under this scheme, you set up the trust with a small gift for the beneficiaries, and then make an interest-free loan to the trustees, who invest it in a bond. Because it’s a loan, you can withdraw capital from the bond whenever you want, but you don’t have access to the growth.

The remaining capital invested in the bond will count as part of your estate when you die, but the growth part of the investment is outside it and goes to the trust beneficiaries.

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And one for luck… spend more

You can’t take it with you and there’s little joy in the prospect of the taxman getting his hands on a big chunk of what’s left, so why not enjoy your wealth to the full with your friends and family and by enhancing your life in practical ways? That way, you may be able to keep the value of your estate below the inheritance tax threshold altogether.