Labour’s Budget dilemma as IHT raid remains option

What a difference a year makes. In the lead-up to the 2023 Autumn Statement, rumours swirled that then-Chancellor Jeremy Hunt may halve the 40% inheritance tax (IHT) rate in a bid to woo voters with an election coming down the track.

Ultimately, this didn’t come to pass, but as we head towards this year’s event, reports of IHT cuts are non-existent. In a stark reversal, the mood has pivoted to hikes as the government seeks to fill the apparent £22 billion fiscal “black hole”.

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Whatever happens in the House of Commons on 30 October, many feel that IHT reform is long overdue. The current system is monstrously complicated in parts, and unfair in others.

Labour, however, faces a dilemma. On one hand it must find ways to balance the Treasury’s books. But on the other, canning or restricting some tax-free exemptions, such as those for businesses and within pensions, could hurt the UK’s economic growth ambitions and stick a spanner in diligent savers’ plans.

IHT receipts continue upwards march

While it may be small fry for the government compared to other taxes, IHT still makes a useful contribution to public finances, and the amount is ticking up sharply with each passing year. The latest HMRC data shows that payments climbed to £3.5 billion between April and August 2024, £0.3 billion higher than the same period last year.

The lack of reform is a key reason for this trend. The nil rate band, the value of assets you can own tax free, has remained at £325,000 since 2009, and isn’t scheduled for review until 2028. Two decades is an exceptionally long period for a tax threshold to stay static.

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And it’s not just tax-free lifetime limits that have been frozen. The annual exemption, the amount you can give away every year without it being added to your estate, has been fixed at £3,000 for an astonishing 43 years. If this allowance had increased every year in line with inflation, it would now stand at a heftier £11,240.

What areas could the government reform at the Budget and what’s the likelihood?

• Scrapping or reducing some tax-free reliefs

This is where most of the rumours have centred on. Axing or lowering business relief and/or agricultural relief is possible but could harm the UK economy, according to some experts. And boosting growth is a core tenet of Labour’s strategy.

A report by Family Business UK said that without business relief, “shares passed as a result of the death of a family member would mean the inheritance tax liability would likely be borne by the business itself”, which could force an unwanted sale.

The report added that business relief “takes away the disincentive for families to grow their businesses, invest and create new jobs”.

Meanwhile, the Country Land and Business Association (CLA) said that removing agricultural relief could compel many farmers to sell land to pay IHT, “putting livelihoods, and the nation’s food security, at risk”.

• Restrict or remove IHT relief in pensions

Canning or restricting the IHT-exemption in pensions is an obvious target for the government. At present, pensions are exempt from IHT, although beneficiaries may pay income tax on withdrawals if death occurs after age 75.

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The problem with closing this loophole is that many savvy savers have ploughed money into pensions over the years to harness the generous IHT perks. If no historical protection is put in place, some may understandably feel the rug’s been pulled out from under them.

• Axe the residence nil rate band

The residence nil rate band grants some homeowners up to £175,000 tax free on death, in addition to the £325,000 standard nil rate band. This brings the potential tax-free allowance for married couples and civil partners to £1,000,000.

However, this allowance is riddled with complexity and unfairness, two things any government should strive to remove from the tax system. To qualify, the property must be left to direct descendants (children, grandchildren, etc), which penalises those who choose to rent or are childfree.

Also, the allowance reduces by £1 for every £2 an estate exceeds £2 million, lowering the number of families that qualify. This aspect isn’t particularly well understood, running the risk of people inadvertently getting caught out.

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For what it’s worth, I would welcome any move to abolish the residence nil rate band as long as the figure is added to the standard nil rate band, giving everyone £500,000, tax free. After all, it was introduced, in part, to make up for the £325,000 limit being frozen. The issue for Chancellor Rachel Reeves (pictured) is that this would likely decrease rather than increase tax revenues.

• Raise the headline rate

I would place this in the unlikely camp. The current 40% flat rate is already high and hiking it may encourage wealthier families to take more aggressive action to swerve IHT altogether, rather than accept that their loved ones may have to pay a bit.

• Keep things as they are (for now)

Despite what the rumour mill suggests, it’s possible the government could leave things unchanged, content to keep tax thresholds on hold and let rising asset prices boost revenues in a stealthy way.

In fact, this tactic alone is forecast to double the annual IHT take to £15 billion by 2032-33, according to the Institute for Fiscal Studies (IFS). Doing nothing would also pave the way for Labour to start from scratch and launch a considered and in-depth review of the IHT landscape.

How to plan for IHT in six steps

While we don’t know what the chancellor will do in four weeks’ time, IHT was once dubbed “the voluntary tax” for good reason. Here’s a simple six-point checklist to help you plan your estate in a tax-efficient way.

1) Work out your potential liability

Before you start taking steps to avoid IHT, it’s important to first work out if you have a liability, and if so, how much it is likely to be.

As noted above, everyone can pass on £325,000 tax free, and if you own a home that you plan to leave to children or grandchildren, you could get an extra £175,000. But anything above these allowances (that isn’t IHT exempt) is taxed at a rather painful 40%.

2) Write a will (or update an existing one)

An accurate and up-to-date will is a cornerstone of prudent estate planning. Put simply, it’s a legal document that ensures your assets end up in the desired hands.

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You don’t have to use a solicitor to make or update your will, but it can a prudent move. That’s because if it’s deemed invalid, the rules of intestacy will determine how your estate will be divvied up once you pass away, which might cause family friction.

3) Use tax-free gift exemptions

Getting a good grasp of these will come in handy.

You can gift £3,000 a year without paying tax and bring forward £3,000 from last year if unused. Parents and grandparents can each make marriage gifts of £5,000 and £2,500, respectively.

Provided you can prove it doesn’t impact your standard of living, you can also hand out as much of your surplus income as you like.

4) Make larger gifts where sensible

For gifts that exceed the above exemptions, in most cases you must survive seven years before the asset moves outside your estate – so it’s best to give stuff away while you’re healthy.

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If you don’t want to lose control of the asset completely, then trusts can be an option. Make sure you seek professional advice here as these are complex legal instruments.

5) Consider tax-exempt investments

It might be worth considering assets that are exempt from IHT, provided they’re suitable.

These include pensions, such as self-invested personal pensions (SIPP), and AIM shares. The latter offer 100% relief as long as the companies are qualifying and held for at least two years. Note, you must be prepared to stomach sharp ups and downs as AIM shares can be volatile.

6) Don’t forget your lifestyle…

It’s natural and indeed savvy to seek ways to reduce IHT, putting more money in your family’s pocket and less in the taxman’s. But it’s important not to jeopardise your own lifestyle in the process.

The key here is to start early and plan effectively, which can enable you to find a healthy balance between saving IHT and living in financial comfort.