Six easy (and completely legal) ways to avoid inheritance tax

Inheritance tax is often known as Britain’s most hated charge, but until recently it was only the very wealthy who had to pay it.

More and more families are now predicted to be caught up in the inheritance tax trap as the value of property has soared – pushing many estates over the threshold.

Data released earlier this year by HM Revenue and Customs showed IHT receipts had reached an all-time high of £7.1bn, a £1bn increase on the previous high of £6.1bn in 2021-22. For estates that do get caught out, the tax burden can be huge. 

How much can I inherit before I have to pay tax?

Upon death, the tax is charged at 40 per cent on the value of the estate above the tax-free threshold of £325,000 – eating into your loved ones’ inheritance.

As a nation we are paying more death duties than ever before. HMRC raked in a record-breaking £6.1bn in 2021-22, up 14 per cent year-on-year.

Rising property prices and a 20-year freeze on the inheritance tax threshold are pulling more families into the net and causing bills to swell in size. The Government’s decision in the Autumn Statement to freeze tax thresholds until 2027-28 is forecast to net an extra £1bn that families would not have had to pay were the bands uprated with inflation.

Rachael Griffin, of wealth management firm Quilter, said: “Inheritance tax has historically been viewed as a tax for the very wealthy, but in recent years we have seen an increase in the number of people being caught in the net.”

Ms Griffin said: “Many people could now find themselves in a position where they end up paying IHT unnecessarily, as they may never have previously considered the need for IHT planning and therefore have not taken the steps required to mitigate it.”

So with more and more estates in danger of the hated tax, here’s how to avoid paying it on your fortune.

Give assets to your spouse

If you want to cut your inheritance tax bill, then it helps to tie the knot. You can pass on assets of unlimited value to a spouse or civil partner without any IHT liability. According to HMRC, such transfers saved spouses a collective £2.6bn in IHT in 2019-20, the most recent year for which data is available.  

Since the rules changed in 2007, spouses have also been able to inherit their partner’s unused nil-rate band when they die. This means the surviving spouse could see their allowance grow to £650,000.

However the unused allowance is not passed on automatically. You must make a formal claim to HMRC within two years of the death of the surviving spouse – otherwise your family could face an unnecessary tax bill.

Now read: The little-known trick that could save you up to £1.5m from inheritance tax

Leave your home to your children

For many families a property will be their most valuable asset. In fact, rising property prices are a major reason why annual IHT revenue has doubled over the last ten years.

Fortunately, homeowners get an additional £175,000 allowance – called the “residence nil-rate band” if they pass their main property to family members. And because spouses and civil partners can combine their allowances, they can pass on a total of £1m wealth without incurring a tax bill.

But it pays to be aware of some age restrictions. Ian Dyall, of wealth manager Evelyn Partners, said: “The property must be a residence of the deceased and it must be left to children or grandchildren (not nephews, nieces, brothers or sisters).”

Ms Griffin said although the residence nil rate band was introduced “to ease pressure on the transfer of the main residence”, the rapid growth of house prices means many who are entitled to it will nonetheless face hefty bills.

For estates worth more than £2m, the residence nil-rate band allowance is reduced at a rate of £1 for every £2 over the threshold. If the residence nil-rate band is not enough to protect your wealth, then you should make the most of gift allowances.

Now read: How to give away a £4m estate and pay no inheritance tax

Give away money

Perhaps the simplest way to avoid an inheritance tax bill is to give away your assets during your lifetime.

An often over-looked but highly tax-efficient method is to give money out of surplus income. This must be money you can give away regularly without significantly changing your lifestyle; it cannot be money that comes from a house sale, for example. 

Chris Etherington, of tax firm RSM, said: “The gifts don’t need to be of equal size – they just need to be part of a pattern. You should also keep detailed records of the gifts made, in case HMRC asks for evidence of the gifts after death.”

On top of gifts out of surplus income, every individual gets a £3,000 annual exemption. Not many realise this can be carried forward for one tax year – so you could give away £6,000 if your allowance was unused in the previous year.

There are additional allowances for weddings or civil partnerships, although how much you can give varies depending on your relationship to the bride or groom:

Another exemption is the small gift allowance, allowing you to give away up to £250 each year per person – though not to anyone who has already benefited from your £3,000 annual exemption.

All of these gifts are immediately free from inheritance tax – that is to say, they are excluded from your estate. For gifts outside these categories, a seven-year-rule applies.

The seven-year inheritance tax rule

Large gifts in excess of £3,000 can be made without incurring IHT – but only if you survive the gift by seven years. During this window, the gifts are called “potentially exempt transfers”. Gifts made within three years of death are taxed at the full rate of 40 per cent  – after that, taper relief will apply at the following rates:

More and more taxpayers are falling foul of the seven-year rule. Families were charged £197m on “potentially exempt transfers” in 2017-18, up from £156m in 2016-17 and £135m in 2015-16, according to figures from HMRC.

This is why it may make sense to give away more money at a younger age. However, Mr Dyall said: “It is obviously important to consider how much you can afford to gift in this way without leaving you or your spouse vulnerable.”

Now read: What the seven-year rule for inheritance tax is – and what it means for you

Pass on your pension

Regardless of whether you have touched your pension savings, you can pass on the entire pot to your beneficiaries inheritance tax-free. 

So even if you had used up your nil-rate band and residence nil-rate band, you could still give away £200,000 in pension wealth, thereby saving £80,000 in IHT. 

Just note that the beneficiary will have to pay income tax as they draw down on the pension, but only if the original pension holder dies after age of 75. Mr Dyall said another advantage of incorporating pensions into your estate planning is you can still access these funds if you ever do need to draw on them to pay for care.

Now read: How to use your pension to avoid inheritance tax

Take out a life insurance policy 

If there is nothing you can do to avoid IHT, you can still insure against the final bill. Taking out a life assurance policy means that when the IHT is due, the charge can be paid out of your policy rather than by your beneficiaries. 

However, it is important the policy is placed inside a trust to shield it from the estate. Otherwise the payout will increase the estate’s value and potentially the amount of IHT due as a result. Also, these plans can be very expensive. The older you are, the higher the premiums will be.

This article is kept updated with the latest information.