As inheritance tax receipts hit a record £7.1billion a year, a growing number of families are looking for ways to slash their costs.
From making gifts during your lifetime to setting up trusts, there are many legitimate ways to pass down money to loved ones without incurring tax. But before you steamroll ahead it is worth doing your homework.
Fail to abide by the strict rules and you could inadvertently land your family with an unexpected tax bill.
Wealth & Personal Finance has identified eight major pitfalls that you should be wary of when planning the future of your estate, and how much they could cost you.
Watch out: As inheritance tax receipts hit a record £7.1bn a year, a growing number of families are looking for ways to slash their costs
1 Hand over home and stay in annexe – £115,000 hit
Parents often want to pass on the family home to their children – but without landing them with a massive tax bill.
A property worth up to £1million can be handed by a couple to direct descendants tax-free – but anything above this is charged at 40 per cent.
A single person with children can pass on a home worth half that sum tax free. Therefore it can be tempting for parents to hand over a family home during their lifetime, in the hope that it won’t form part of their estate for inheritance tax purposes.
There is no inheritance tax to pay on gifts so long as you live for a further seven years after making them. However, this plan can easily backfire if done incorrectly. That is because if you continue to live in the home after gifting it, it is considered a ‘gift with reservation of benefit’.
That means that the property is not deemed a genuine gift because it comes with strings attached.
Should this happen, the property may still be considered part of your estate when you die and therefore could attract inheritance tax.
Ian Dyall, estate planning specialist at wealth manager Evelyn Partners, says: ‘Generally, gifts will only be effective in mitigating inheritance tax if there is no continued use of the gifted assets and no strings attached, saying that they can be returned to the donor.’
The impact of this will depend on what the property is worth and what other assets you have. If, for example, you gifted your child a second home, but still used it regularly for holidays, your family could be hit with a bill of about £115,000.
This assumes that you own your own home and that it is worth more than £325,000 – or £650,000 if you’re a couple – and have a second home worth the average UK house price of £288,000. To mitigate the risk, you could pay your child rent if you plan to continue using the property.
But be careful: you must pay rent at the going market rate for it to be valid. And your children would have to pay income tax on the rent you paid them.
2. Sell up and buy home together – £27,000 hit
Don’t think you can get around the rules by selling your home and gifting your children the cash to buy another one.
Dyall says he often sees cases where parents sell their home so their child can buy a bigger property for them to all live in together.
However, because the children then allow the parents to live rent-free, they risk a shock tax bill. ‘In some cases it is done completely innocently,’ he says, ‘perhaps by families buying a new home together so the grown-up children can provide care for an infirm parent.’
Be careful: Don’t think you can get around the rules by selling your home and gifting your children the cash to buy another one
Families who do this risk falling foul of either ‘reservation of benefit’ rules, which would lead to an inheritance tax bill, or so-called ‘pre-owned asset’ legislation, which would lead to an income tax bill.
The latter would mean you could be landed with an income tax bill based on the rental value of the property. For example, if you sold your home and handed the cash to your child to buy a home for you all to live in together, Revenue & Customs would work out what share of the property came from your gift, add the annual rental value of that share to your income and charge you income tax on it.
It is effectively billing you for the benefit it deems you to have received. On the average UK rent of £1,126 a month, according to Zoopla, this would amount to a tax charge of £2,702 a year (or more for higher rate taxpayers). Over a ten-year period, that amounts to £27,024.
3. Make half-hearted gifts – £3,500 hit
If you make a gift, ensure you do it properly and formally. For example, if you hand over a painting, do so physically – even if it means leaving an unsightly space on your wall.
You should also make sure the beneficiary adds it to their home insurance – and you take it off yours – so there is evidence that the gift has been made.
Mike Warburton, a former tax director at the accountancy firm Grant Thornton, says: ‘There is a temptation, for example, to say after your parents have died that their valuable Old Master had been given to you seven years ago.
‘Contrary to some rumours, tax inspectors are not stupid. Apart from the insurance issue, when the solicitor handling the estate calls round, what is your answer for the suspiciously clean patch on the wall where it used to hang?’
Revenue & Customs will often investigate if gifts were made seven years before the giver died. It has access to huge amounts of personal information via a database called Connect, says Robert Levy, a specialist in tax investigations at law firm Kuits Solicitors.
There is no time limit on how long the taxman has to open an investigation into this. The interest charged on unpaid inheritance tax is currently 7.75 per cent.
A penalty can then be added to this, depending on the reason for underpayment. Where a mistake has been made, or there was lack of reasonable care, families could pay up to 30 per cent of the extra tax due. So if you had a painting worth £5,000, and failed to pay inheritance tax on it, after five years you would owe £905 in interest, £2,000 in the initial unpaid inheritance tax and £600 as a late penalty – amounting to £3,505.
4. Fail to put life cover into trust – £45,000 hit
Life insurance policies are often taken out to pay out to loved ones on the policyholder’s death.
But failing to set up the policy properly could needlessly land them with an inheritance tax bill. Life insurance policies can be put into trust, which means they are not included as part of your estate for inheritance tax purposes.
However, nearly 7,000 estates paid inheritance tax on life insurance payouts in 2020-21, according to the latest data.
These life insurance policies were worth £830million, which means up to £332million of inheritance tax may have been paid unnecessarily.
Sean McCann of wealth manager NFU Mutual says if a policy is not put into trust, it will be included in your estate. This means that up to 40 per cent of the payout could be lost to the taxman from the outset. On a policy that pays out £100,000, this would amount to a £40,000 bill.
‘Putting life insurance policies into trust is straightforward and many providers make trust forms available free of charge,’ he says.
5. Put pension cash into savings – £10,000 risk
Pensions can be a very tax efficient way of passing on money to loved ones. They can be passed on tax-free if the giver dies before the age of 75.
If they are older, the beneficiary pays income tax when they subsequently withdraw money from the pension.
However, pension holders often unwittingly jeopardise their tax-free status by needlessly withdrawing money from it and putting it into a savings account instead.
Once money is out of the pension, it is no longer safe from inheritance tax. This is a problem because pension holders frequently take advantage of their right to withdraw a 25 per cent tax-free lump sum from their pension whether or not they need the money.
Pensions: Pensions can be a very tax efficient way of passing on money to loved ones
McCann says: ‘Many people take significant sums from personal pensions, often with no clear idea of what they intend to do with the money, with many choosing to put it straight into a savings account.
‘It’s important to remember that money remaining in your pension on your death is normally free from inheritance tax, whereas savings accounts and most other investments are included when calculating an inheritance tax bill.’
For example, if you took £25,000 from a £100,000 pension pot and put it into a savings account, your beneficiaries would face a £10,000 bill when they inherited it. Whereas if you had left it in a pension, they may not have had to pay a penny.
6. Miss joint allowance – £200,000 hit
Couples who are married or in a civil partnership can combine their inheritance tax allowances.
A single person has an allowance of £325,000, but a couple has one of £650,000 to be used on the death of the remaining spouse.
However, many people do not realise that widows or widowers retain their deceased spouse’s inheritance tax allowance even if they remarry.
If you remarry, you can combine your inheritance tax allowance with that of your new spouse.
McCann says: ‘Many people who have been widowed and have remarried don’t realise they can potentially leave up to £1.5million free of inheritance tax. If their spouse was also widowed, they could leave up to £2million.
‘It’s important for anyone who has lost a spouse and remarried to take advice to maximise the sum they can leave tax-free to their family.’
For example, a widower who plans to leave the family home to his children could pass on a property worth £1million tax-free.
His new bride would also have her own allowance worth £500,000, assuming she too wishes to pass on a family home. Together, they can pass on a tax-free estate worth up to £1.5million.
7. Fail to tie the knot – £70,000 hit
You may have been with your partner for decades, have a home together, children, and shared finances.
But you will only enjoy the inheritance tax benefits of a couple if you are married or in a civil partnership.
If you own a property with your partner as joint tenants, your partner’s share will pass to you automatically if they die first.
However, their share still forms part of their estate for inheritance tax purposes so you may face a tax bill. If the property is worth £1million, their share would be £500,000 and so inheritance tax would be payable at 40 per cent on the sum above their tax-free allowance of £325,000. That would amount to a hit of £70,000.
8. Unclaimed overpaid IHT – £40,000 HIT
Inheritance tax usually has to be paid within six months of a death and is based on an estimate of the value of deceased’s assets on the day they died.
If the executors sell a house within four years of the death at a lower value they can reclaim the overpaid IHT.
Refunds are particularly common when house prices are falling, as the price achieved on a property is more likely to be less than had been expected. You can also claim back on shares and other qualifying investments that are sold at a lower value within 12 months of the death.
More than 5,000 families claimed a refund in the 2022-23 tax year after overpaying, official data shows.
That is up 22 per cent on the previous year.
McCann says: ‘Let’s take the example of someone who dies leaving significant assets, including a house worth £1million. Eighteen months after their death, the executors sell the property for £900,000. They could reclaim the inheritance tax on the £100,000 fall in the house price, resulting in a £40,000 reclaim for the beneficiaries.’
