Inheritance Tax (IHT) is one of the steepest taxes in the UK, charged at 40% on the value of your wealth and assets, collectively known as your “estate”.

There is a nil-rate band (NRB) before IHT is due, which as of the 2021/22 tax year is £325,000.

There’s also an additional residence nil-rate band (RNRB) of £175,000 if you pass your home to your direct descendants. This means you could pass on up to £500,000 tax-free.

And, if you’re married or in a civil partnership, you’ll be able to pass any unused NRB to your partner on your death or vice versa, meaning you may be able to pass on up to £1 million between you without incurring a tax bill.

While this might seem a lot, and you may feel you wouldn’t be affected, rising property prices and strong investment returns over your lifetime could easily see your wealth exceed this amount by the time you pass away.

Any value in your estate over the nil-rate bands will typically be subject to a 40% IHT charge unless you consider strategies to mitigate your position.

Fortunately, there are various ways to do this. Here are just five methods you could consider for mitigating a potential IHT bill.

1. Gifting

Gifting means giving your money or assets directly to your chosen beneficiaries during your lifetime.

This ensures that your chosen beneficiaries receive the inheritance you want them to, and mitigates IHT by reducing the overall size of your taxable estate.

There are a few key allowances and exemptions that you should consider making the most of when gifting.

Remember: make sure you keep accurate records of any gifts you make in your lifetime. This ensures that your executors know not to include them when calculating the value of your estate.

Annual exemption

The gifting annual exemption is a tax-free lump sum available to you and your partner each tax year.

You can gift up to £3,000 (or £6,000 for married or civil partnered couples) in a single tax year with the amount falling outside of your estate.

So, making the most of this amount each tax year can help reduce your estate over time.

You can also make an unlimited number of small gifts of up to £250, although not to the same person who received your annual exempt amount.

Wedding gifts

There is an additional exemption for gifting when the money goes to couples who are getting married, depending on how you know the married couple:

  • Parents can give up to £5,000 to their children
  • Grandparents can give grandchildren up to £2,500
  • You can give other relatives or friends up to £1,000.

Consider making the most of the wedding gift exemption whenever possible.

Gifting from income

As well as these exemptions, you can also save on IHT by making regular gifts directly from your income.

For example, you could make payments for your grandchildren’s school fees directly from your pension income each month.

An important part of this is being able to prove that the gift does not affect your lifestyle and that the gifts come from income, not capital. If your gifts mean you have to change your lifestyle, they may become subject to IHT.

The seven-year rule

In theory, you can actually gift as much as you like without incurring an IHT bill, provided that you survive the gift by seven years or more.

If you die within these seven years, the gift will be subject to “taper relief”, meaning the IHT rate depends on how many years have passed between making the gift and your death:

Even if you don’t survive the gift by the full seven years, you could still reduce the impact of IHT by gifting in your lifetime.

2. Using your pension

As the money in your pension will generally fall outside your estate, you could reduce a potential IHT bill by drawing your income in retirement from other sources.

Consider accessing your savings or liquidating your investments to live on during retirement, while leaving your pension untouched.

This would see your pension go to your beneficiaries without being subject to IHT in most cases.

Bear in mind you may have to pay Capital Gains Tax (CGT) on any non-ISA investments you cash in, depending on how well they’ve performed.

You should also consider taking financial advice before using this strategy to make sure you can afford to live in retirement without using your pension savings.

3. Life insurance held in trust

Life insurance can be a useful tool for mitigating IHT, as long as the policy is held in trust.

Trusts involve putting money away for a specified individual, known as a “beneficiary”. You then appoint a “trustee” who will give the beneficiary access to the trust at a time of your choosing.

The main benefit of using trusts is to protect money for certain beneficiaries. Even so, they do confer certain IHT benefits, particularly for life insurance.

When your executors come to calculate the total value of your estate, they’ll work out how much IHT you owe. Your family will then have to pay this bill before they can access the inheritance you’ve left for them.

But a life insurance policy contained within a trust will fall outside the value of your estate. This means your family will be able to access this money quickly on your death.

So, once you’ve calculated your estate and worked out how much IHT you’ll owe, you could consider taking out a life insurance policy with a payout equivalent to the IHT bill.

Then, on your death, your family will quickly receive the lump sum payment from the policy which they can use to pay this bill, allowing them to inherit the remainder of your estate IHT-free.

This can help to relieve your family of the burden of administering your estate and finding the money to pay IHT, making it more straightforward for them at a difficult time.

4. Equity release

As any value in your home above the RNRB will be subject to IHT, you could consider using an equity release product and living on that tied-up money.

Generally speaking, there are two types of equity release product:

  • Lifetime mortgage, in which you take out new borrowing on your home and then either pay off the interest during your lifetime or allow interest to accumulate until you die or move into care. Most lenders will have a cap of the property’s maximum value for how much interest you can accrue.
  • Home reversion, in which you sell all or part of your home to someone else, while retaining a legal right to remain living there.

This strategy means that you receive a lump sum to live on, while the remaining value in your home falls below the RNRB. This can be particularly useful if your home has risen in value since you bought it.

Bear in mind that equity release can affect means-testing for later-life care. Factor this consideration into your decision.

5. Charitable donations

Another option you could consider is to make charitable donations in your will.

Money left to charities or political parties in your will automatically falls outside your estate.

Additionally, if you leave 10% or more of your will to charity, the government will reduce your IHT rate from 40% to 36%.

This means you’ll pay less IHT while also contributing to causes that mean something to you.

Work with us

If you’d like to find the most suitable methods for mitigating IHT in your personal circumstances, please speak to us at Digney Grant.

Email or call +44 (0)28 3082 8880 to speak to one of our experienced advisers.

Please note

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.

Equity Release will reduce the value of your estate and can affect your eligibility for means-tested benefits.

This article is for information only. Please do not act based on anything you might read in this article. All contents are based on our understanding of HMRC legislation, which is subject to change.