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Inheritance Tax (IHT) received no mention in the Chancellor’s March 2020 budget. This surprised many commentators since there had been rumours of reforms to the system over the past few years (which is widely seen as cumbersome and complex). Indeed, one influential group of MPs in January 2020 called for the 40% IHT rate to be lowered to 10%, in exchange for a reduction or eradication of certain tax-free ’loopholes’ (e.g. the ’7-year gifting rule’).
These proposals were not implemented, but it seems reasonable to expect at least some change to the system in the coming years. For now, our financial advisers offer this short guide, outlining four potential ways someone can reduce an unnecessary IHT bill.
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#1 Combining allowances
To briefly recap, in 2020-21 IHT is typically a 40% tax on the value of your estate worth over £325,000. Your ’estate’ includes things such as your property, possessions (e.g. jewellery) and investments (although not your pension).
Suppose you are single (never married) and your house is worth £600,000. You have £100,000 in ISA savings, and possessions worth £100,000 (e.g a sports car). Together, your estate could be worth £800,000. This means that £475,000 could face a 40% IHT bill, if you do not pass any of it to charity or to direct descendants.
For married couples and civil partners, however, you can combine your IHT allowances. If your spouse dies without using any of their allowance, for instance, then you should be able to inherit it and combine it with your own (i.e. £650,000). In the £800,000 scenario above, therefore, only £150,000 might be liable to 40% IHT.
#2 The residence nil rate band (RNRB)
On the 6th of April 2017, the Chancellor introduced a scheme which could allow an individual to raise their IHT-free threshold. To do so, you needed to ensure that your family home is passed on to direct descendants (e.g. children or grandchildren) when you die.
In 2020-21, this additional allowance represents £175,000. So, to take the above £800,000 scenario again, if you ensured that the house went to your children, then a single person could hope to pass on £500,000, free from IHT (rather than £325,000).
However, married couples and civil partners can also combine this allowance. When you total all of this up, it isn’t uncommon for our financial advisers to help couples create an estate plan which is completely free from IHT. After all, the total potential combined IHT-free allowance for a married couple in 2020-21 is £1m!
#3 Leveraging pensions
Remember how your pension pot is usually excluded from the value of your estate, for IHT purposes? In 2020-21, this arrangement can make your pension a powerful IHT planning tool. Not only can it be leveraged to provide an income in retirement; it can help pass more to your beneficiaries.
In 2020-21 you are allowed to contribute up to £40,000 per year into your pension due to the annual allowance rules; or up to 100% of your salary (whichever is lower). This assumes that you do not trigger the Money Purchase Annual Allowance rules, which lowers your annual allowance to £4,000. Note that those with higher earnings may have a lower Annual Allowance due to tapering rules.
Speak with your financial adviser about how to plan carefully with your pension. Bear in mind that if you die before the age of 75, your beneficiaries pay no tax on any pension money they receive. After this age, however, any withdrawals they make will be added to their income tax bill, which could push them into a higher tax bracket.
Please note that children cannot inherit final salary (defined benefit) pensions or state pensions.
#4 Using gifts
There are many other possibilities for your IHT mitigation strategy. The final one we will mention here is the use of gifts. In 2020-21, you are allowed to give away up to £3,000 per tax year without this getting counted as part of your estate. You can also make as many individual £250 donations as you want, to different people.
Additionally, there are further allowances or exceptions in certain situations. You can make a £1,000 gift towards a wedding, for instance, and this can be raised to £2,500 for a grandchild and £5,000 for a child. You can also give money to help cover someone’s living costs, free from IHT, as well as donate to charities and political parties.
Bear in mind that if you make a gift outside of the exemption regime, then you’ll usually pay 40% IHT on the gift if it was made within three years of your death. However, for gifts made 3-7 years ago, the exact rate you’ll pay ’tapers’ depending on how long ago it was made.
Conclusion & invitation
If you are interested in reviewing this part of your financial plan, then we’d love to hear from you. Get in touch with a member of our financial planning team here at Vesta Wealth in Cumbria, Teesside and across the North of England.
Reach us via:
t: 01228 210 137
e: [email protected]