Nine tips to get an A* in IHT planning

Today is a nervy one for students up and down the country, as roughly 800,000 sixth-formers will find out their A-level results.

For proud parents and grandparents of this cohort, studying for exams may seem a distant memory. But there are times throughout adult life where it pays to knuckle down and do your homework. One such area is in finding ways to shield your wealth from the dreaded inheritance tax (IHT); which at a flat rate of 40% can take a painful chunk out of your hard-earned legacy.

• Invest with ii: Open a Low Cost SIPP | What is a SIPP | Interactive investor Offers

Due to a combination of rising property prices and frozen tax-free thresholds, more and more estates are getting caught in IHT’s net. Payments hit a record £7.1 billion in 2022-23 and are set to rise even higher this year.

If you have an IHT problem, you may wonder whether the steps you have taken so far have made the grade. Either way, now might be a good time to do some revision. Here are nine tips to put you on track to achieve an A*.

1) Get started

Much like studying for A-levels, IHT planning is not something you can cram at the last minute and expect to get top marks. The earlier you can start the better, as this approach gives you more time to get your affairs in order. In some cases – as I explain below – you might have to live for several years before the steps you take become effective.

This doesn’t mean you have to act immediately. But starting early will provide a yardstick of the potential impact of IHT both right now and down the line.

2) Make a will…or update a current one

Whether you have a potential IHT liability or not, it’s vital that you have a valid will in place. This enables you to distribute your assets in line with your wishes when you die. It also allows you to name those people (called executors) who you entrust to carry out your wishes.

As things can change over time, it’s important to revisit your will periodically to make sure it’s still up to date. In some cases, it might be best to make a new one.

When writing a will, it’s typically best to get advice from a solicitor. That’s because if it turns out to be invalid, your wishes may not be granted. You estate could be bound by the rules of intestacy, which are extremely rigid. This might cause friction among your heirs, especially if your family situation is complicated.

• Could your pension be the solution to your inheritance tax woes?
• What are your financial blind spots?

3) Work out your potential bill

Before you take steps to avoid IHT, it’s important to find out how much tax your estate is likely to pay. Everyone gets a tax-free allowance of £325,000, called the nil rate band, and if you own your home, you can get an additional £175,000 (though if your total estate is worth more than £2 million, you might see this allowance reduced or even lost).

Anything above these thresholds is typically taxed at 40%.

But IHT is often more complicated. Some assets, such as a business or a farm, might be IHT exempt, while if you’re a widow or widower and you have remarried, you might get an extra nil rate band.

4) Swot up on gifting rules

Other than spending your money, gifting is one of the simplest ways to save on IHT.

With some gifts, the money moves outside of your estate immediately. Let’s explore those first.

You can give away £3,000 a year (and also carry forward last year’s allowance if unused), either to one person or split it between several.

• Give away your wealth to save mega tax bill: your guide to gifting rules for IHT
• Grandparental giving: sharing your wealth and seeing the benefits

You can also make as many small gifts of £250 as you like (provided you haven’t used another allowance on the same individual); parents and grandparents can gift £5,000 or £2,500, respectively, for weddings; and you can give away any surplus income you have, as long it doesn’t affect your standard of living. Anything you donate to charity is also IHT exempt.

Almost every other gift is classed as “potentially exempt”, which means there will be no IHT if you survive seven years. If the value of the gift exceeds the nil rate band, a taper applies to the proportion above. This reduces the amount of IHT payable from year three onwards.

5) Consider assets exempt from IHT

You don’t always have to give money away to reduce your future tax bill - some parts of your investment portfolio might already be IHT exempt.

For example, anything you hold in pensions, such as SIPPs, typically escapes IHT. So, if you have some spare cash, it might be worth topping your pension up. The one caveat is that if you die after the age of 75, whoever inherits the pot might have to pay income tax on any withdrawals.

Shares listed on the Alternative Investment Market (AIM) can also offer relief from IHT (under business relief) provided they have been held for two years and you invest in qualifying companies. However, the AIM comprises fledging businesses so expect plenty of volatility. You could end up with less than what you originally invested.

6) Get the whole family involved

It’s fair to say there is more to estate planning than just saving tax. It can also be about supporting younger generations financially when they need it most.

It therefore makes sense to get adult children, and perhaps even grandchildren, involved in the process.

There are a couple of reasons for this. First, your heirs will know who will be tasked with what when the time comes to sort out your estate, especially if some are named as executors in the will.

• Tips on gifting and inheritance tax
• Five ways to take control of inheritance tax

Second, sometimes you might want to skip a generation when gifting. If your adult children are already financially secure, passing assets to them may reduce your IHT bill but increase theirs. Moreover, your grandchildren, especially those at university, may have the greatest financial needs. Having an open conversation within the family unit will help you establish the best course of action.

7) Watch out for other taxes

IHT isn’t the only tax you need to consider when gifting money or assets. Depending on what action you take, other taxes might also come into play.

For instance, if you were to transfer a property or portfolio of shares to a younger family member, you could pay between 10% and 28% in capital gains tax.

Meanwhile, if you plan to draw money out of your SIPP to give away, then you will need to watch out for income tax. If you’ve already taken your 25% tax-free cash, any further withdrawals will be taxed at your marginal rate. What’s more, and as mentioned above, any money in pensions typically escapes IHT, so it’s often prudent to give away non-exempt assets first.

8) Use trusts to keep control

For those of you who want to retain some control over how your assets are distributed, both now and in the future, a trust might help.

Trusts are legal arrangements that allow you to move assets outside of your estate without gifting them outright. Note the same seven-year rule on gifting applies, and you appoint trustees (one of whom can be yourself) to manage and distribute the assets when you see fit.

• Helping your child buy their first home? Make sure you do it tax-effectively
• Tax implications of owning a second home

With some arrangements, such as discounted gift trusts, you can lose access to the capital but still enjoy a regular income. If this appeals to you, speak with a financial adviser.

A note of caution here though. Trusts can be fiendishly complex, and sometimes carry hefty tax implications, especially if the gift to the trust is significant. Legal advice here is essential.

9) Finally, don’t neglect your own needs

More often than not, the goal here is to work out how to give money away without leaving yourself short.

While it’s great to relieve your offspring of a large tax bill once you pass, it’s important not to jeopardise your own needs in the process. The key is to strike the right balance, and in many cases, by taking the right steps this is well within your reach.

When it comes to IHT planning, the equivalent of an A* at A-level is peace of mind; the confidence that you can enjoy your retirement and financially support your offspring while keeping HMRC’s take to a minimum.