Four tricks to avoid an inheritance tax headache

We share four ways to reduce or entirely avoid paying the dreaded 'death tax' by savvy financial planning.

Inheritance tax (IHT) is often viewed as a ‘voluntary tax’, in that it is perfectly legal to plan ahead so that you can sidestep having to pay it. All that it requires is enough time to carry through the careful application of some savvy financial planning and you can do just that.

1 First things first: review your will

Many wills that were written years ago still contain outdated tax planning featuring a nil rate band discretionary trust, and this could mean that your estate loses out on being able to use the residential nil rate band (RNRB). This is an additional allowance (introduced in April 2017) which can be claimed if property is directly inherited by your descendants.

It is very important to ensure that your will and estate are structured correctly to fully benefit from this allowance, which could save up to £70,000 in inheritance tax once the allowance is at its maximum level after April 2020.

Alongside this, it makes sense to use other allowances where possible – you can gift £3,000 a year to anyone and it doesn’t count towards your final estate value for tax. Consider also giving away surplus income instead of saving it; this is a vastly underused allowance. It is very important to keep records so all these gifts can be justified and proved to the HMRC when the time comes to wind up your estate.

2 Invest correctly

If you hold shares on the Alternative Investment Market (Aim) that qualify for business property tax relief, and you continue to hold them for at least two years and at your death, they will tick the inheritance tax exemption box.

Aim shares can also be held within an Isa (since August 2013), so if you have holdings in an Isa you could consider transferring some investments to Aim shares to benefit from this valuable tax relief. That way, you still have all the benefits of maintaining access to your cash and income, without the need to give anything away now.

A word of caution, though: Aim investments are considered to be much higher risk compared to shares listed on main markets such as the FTSE 100 index. Therefore, before investing, you need to understand your own appetite for the investment risks that might be involved.

3 Use a trust

Investing using trusts is an obvious way to avoid the bite of inheritance tax. This can be done in various ways. A gift to an individual, outright or via a trust, can achieve a number of things, but usually the settlor (person making the gift) would have to live for seven years to ensure that the value of the gift falls out of their estate. The trust usually gives the settlor some element of control over what happens to the money, and this appeals to many investors who are not yet ready to let go.

Consider special types of trust – using a discounted gift trust, for example, will allow a settlor to retain a right to income from the gift for life, and as a result of this there is a special dispensation with HMRC that discounts the value of the gift for tax purposes from the outset. As an example, if a £100,000 investment is made into this type of trust and the income provided each year is £5,000 payable back to the settlor, HMRC may discount the original investment to around £70,000 if the settlor is aged in their mid-70s.

If he should die within the first seven years of making the investment, the amount considered in his estate for tax purposes would be £70,000, not the actual gift of £100,000. This gives an immediate saving of £12,000 in inheritance tax. After seven years the amount considered for inheritance tax would be zero as the whole amount would be outside the estate.

4) If all else fails, insure for IHT liability

A very old-fashioned idea, but one still valid for couples, is to insure for the tax liability that your loved ones will incur on your death. A joint life insurance policy taken out on a whole of life basis, which will pay out on the second death and is written in trust for your estate beneficiaries, will supply the cash required to meet the inheritance tax liability on the survivor’s death.

Contrary to popular belief, this can be quite a valuable investment when the premiums required to pay for the policy are considered against the value the plan will ultimately pay out. The gamble is that no one knows how long they will live; and as this plan is insurance, you would need to be in reasonable health to obtain the cover.

Angela Murfitt is a chartered financial planner at Fairstone.

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