10 ways to avoid inheritance tax: How to protect your wealth

Inheritance tax at 40 per cent is paid by a relatively small but growing number of people’s estates.

Those whose home or savings drags them into the inheritance tax net often want to avoid loved ones getting lumped with a hefty bill unnecessarily.

Luckily there are many legal ways to dodge the dreaded 40 per cent ‘death tax’ if you want to pass on the maximum sum possible and are prepared to plan ahead.

But Chancellor Rachel Reeves is rumoured to be considering an inheritance tax raid in her Autumn Budget, with some of these crucial reliefs in the firing line.

We explain the ten main ways people can avoid inheritance tax – ranging from the easily accessible, such as giving money away, to more obscure methods mainly used by the asset rich – and likely to be a prime target for the Chancellor.

What you need to know about avoiding IHT

Individuals can leave up to £500,000 and married couples up to £1million free of inheritance tax, which comfortably covers most people’s estates.

But the thresholds – explained in more detail below – have been frozen until April 2028, which means more people’s estates will become liable for inheritance tax.

But you shouldn’t lose sleep – let alone start working on elaborate avoidance tactics – unless you are certain you are rich enough for it to become a problem for your heirs. 

Inheritance tax may be dubbed Britain’s most hated tax but you still need to be comfortably off to worry about it.

Meanwhile, for those considering complicated schemes, remember financial advisers repeatedly remind people that the most cost effective ways to beat inheritance tax are to spend and enjoy your wealth or give it away early.

How inheritance tax works

Around 4 per cent of people leave estates sufficiently large to make their beneficiaries liable for inheritance tax.

However, in addition to the threshold freeze, the property boom of recent decades means the number of families affected is expected to rise in years to come. Those inheriting in house price hotspots will bear the biggest financial burden.

Essentially, you need to be worth £325,000 if you are single, or £650,000 jointly if you are married or in a civil partnership, for your loved ones to have to stump up death duties. 

But there is a further chunky allowance – known as the residence nil rate band – which increases the threshold to a joint £1million if you have a partner, own a property, and intend to leave money to your direct descendants.  

Watch out though, as once an estate reaches £2million this own home allowance starts being removed by £1 for every £2 above this threshold. It vanishes completely by £2.3million

If you are worth more than this, your heirs will have to hand over 40 per cent of your assets above those levels to the Government.

So, how do you reduce or avoid a large inheritance tax bill?

We have compiled a round-up of ways to do so, some of which can be undertaken easily by any ordinary person without the need for convoluted arrangements or to pay for professional help.

Others are complicated, risky, involve hassle and expense, or a combination of the above, and these more onerous options appear further down the list. 

1) Gifts: Hand over your money

You can gift £3,000 a year, plus make unlimited small gifts of £250, free from inheritance tax.

Married people and those in civil partnerships can give each other any sum they like free of tax, provided their partner lives in the UK.

Wedding gifts are also exempt, although the amount depends on how close you are to the bride or groom. The limits are up to £5,000 to a child, £2,500 to a grandchild or great-grandchild, and £1,000 to anyone else.

One less well-known type of unfettered gifting is to contribute to the living costs of someone else – younger or older relatives, for example – but only if you can prove it’s coming out of spare income.

Such gifts must be made out of surplus funds, which means your beneficiaries may have to show HMRC your old bank statements to prove you did not need to spend that money on anything else.

Beyond this, you can hand unlimited sums to other people if you want, but they will fall under the so-called seven-year rule.

Officially, these are called ‘potentially exempt transfer’ gifts, because if you survive seven years the money automatically becomes free of inheritance tax.

If you die before the seven years are up, inheritance tax is levied on a sliding scale – starting at the full whack of 40 per cent if it’s within the first three years.

Check the Government rules on inheritance tax and gifts, and see the table below.

 2) Trusts: Gifts with strings attached

With trusts, you are still giving money away and the seven year rule still applies, but you have more control than if you simply hand over your cash to someone else.

This is often a sensible way of passing on money to children or grandchildren, if you think they are too young to spend it wisely.

A very simple ‘bare trust’ or ‘absolute trust’ allows trustees you have appointed to keep control until beneficiaries are 18 – which might still seem too young especially if large sums are involved.

A ‘discretionary trust’ is more complicated but you can tailor the rules to suit the people involved and the circumstances.

However, trustees have to assess the holdings for inheritance tax every 10 years to satisfy HMRC rules, and tax could be levied both straight away and at a rate of 6 per cent in future.

So, you will need professional help from a financial planner or lawyer to set up a discretionary trust, and probably at intervals in the future too.

If you think you might need the money back at some point, you can set up a gift and loan trust. The trustees can invest the money outside of your estate for inheritance tax purposes, but you can opt to get it back.

The tapered inheritance tax if the person who sets up the trust – known as the ‘settlor’ – dies within seven years applies as shown in the gifting table above.

> Check the Government rules on inheritance tax and trusts.

> Our resident tax expert Heather Rogers explains how trusts work 

3) Life insurance: Put the policy in trust

Taking out life insurance can mean your loved ones get a payout straight after your death and free of inheritance tax – but you have to set it up correctly.

To stop a life policy payment getting rolled into your estate, and the taxman potentially grabbing 40 per cent of anything over your inheritance tax threshold, you need to put it into trust.

That allows you to appoint one or more beneficiaries of the trust, who will be paid the full sum due when you die, and without the delays involved with inheritance payouts.

You can insure your life for the sum you think your heirs will have to fork out in inheritance tax, to offset their liability.

Beware though that premiums can be high, especially as you get older, and if you cancel a policy you immediately lose all the benefits of taking it out in the first place.

You also need to be in good health, to avoid HMRC thinking you are just trying to dodge inheritance tax.

Putting a life policy into trust can be done with the help of a financial adviser, and you might well need legal input too.

> How to put life insurance into trust 

4) Pension pots: Pass your retirement savings on to loved ones

The rules on inheriting retirement savings were relaxed in April 2015, but how much your heirs benefit depends on what type of pension you have and your age when you die.

The main change was the abolition of a hated 55 per cent death tax on pension income drawdown plans left to relatives.

Instead, beneficiaries either pay no tax if the pension holder dies before age 75, or their normal income tax rate – with the money they receive added to their earnings to calculate this – if they are 75 or over.

The abolition of the lifetime allowance has caused fallout which has led to another allowance that relates to tax-free lump sums after death, which is £1,073,100 and includes previous tax-free lump sums and serious ill health lump sums taken while the pension holder was alive.

Find out more about repercussions from the axing of the lifetime allowance here, but if you have that much saved into a pension you should should seek financial advice to avoid costly errors.

Meanwhile, husbands and wives whose partners die before reaching 75 can now get annuity income from their spouse’s pension tax-free.

Previously beneficiaries of ‘joint life’ annuities or other types that come with death benefits paid income tax on what they received.

However, the changes have not affected people in final salary pensions – generally considered the best and most generous schemes.

This has tempted some savers to transfer out to less safe self-invested personal pensions or defined contribution schemes, or to income drawdown schemes if they are at retirement age, in order to leave money to their families.

That’s a big and irreversible decision though, since it means giving up a guaranteed income from retirement until you die, and shouldering all future investment and inflation risks to your pension on your own. 

The rise in interest rates over the past year or so means pension schemes are offering much less generous deals.

Also, savers should beware that HMRC might look askance if you transfer out of a final salary pension while in poor health and die within two years. HMRC could decide to include it in your estate for inheritance tax purposes anyway.

5) Supporting a cause: Give to charities and political parties

You can gift or bequeath money to charities and political parties and it will be excluded from your estate when inheritance tax is calculated.

A political party has to have succeeded in getting at least one MP elected to parliament to qualify for this exemption.

There is also a way to reduce your heirs’ inheritance tax rate from 40 per cent to 36 per cent of your taxable estate by giving to charity – although not to a political party.

You can do this by bequeathing at least 10 per cent of your net estate – the part liable for inheritance tax – to charity in your will.

6) Property handover: Give your home to your kids and pay them rent

Keeping your home in the family and out of the taxman’s clutches sounds like an attractive proposition, but there are pitfalls to gifting a property to your children before you die.

You need to sell your home at its market value, and pay rent at market value too, because if you give it away and pay negligible or no rent that is a ‘gift with reservation’. 

HMRC can therefore still count it in full when it works out inheritance tax.

Your children also need to consider the impact of doing this on their income tax bill. And if they become a buy-to-let landlord in this way, that comes with a host of other rules and tax liabilities that apply even if a family member is their tenant. 

If they get divorced, you might find their ex becomes your landlord. 

Meanwhile, if you give away your property or sell it at a knockdown price to your children, you and they might fall foul of your local council’s ‘deliberate deprivation’ rules if you need to go into a care home in later life.

7) Home ownership: Switch from being ‘joint tenants’ to ‘tenants in common’

Most people who own property together do so as joint tenants. That means they ‘jointly and severally’ own 100 per cent of the home. When one dies the other becomes the full owner, no matter what is said in a will.

Spouses don’t pay inheritance tax so there is no liability at that stage if they get the home after the death of a first partner – although if the co-owner is anyone else it could be due, subject to the usual thresholds.

But if a couple opts to make their ownership ‘tenants in common’, they can split it differently, not just 50/50, and potentially leave their shares to someone other than the other owner, such as their children. 

That reduces the surviving owner’s estate for inheritance tax purposes.

You can switch to ‘tenants in common’ even after one partner has died. 

Under any circumstances, you should get a solicitor if you want to do this. Check the Government rules on inheriting property.

8) Owning a business: Pass on the family firm

To prevent inheritance tax bills capsizing or forcing sales of small firms, the Government offers protections when trading businesses are left to family members.

To qualify for business property relief, you need to have owned a firm or shares in it for at least two years by the time you die.

Privately owned firms and some listed on AIM, the small company arm of the London Stock Exchange, qualify for BPR.

But there are exceptions, such as those in the property or investment sector. There are also separate rules for businesses involving farming and forestry, which we look at in more detail below.

9) Boosting enterprise: Invest in small companies

To encourage investment in smaller business ventures, the Government also gives people protection from inheritance tax if they hold shares in firms with BPR status for at least two years.

Some specialist investment firms offer schemes helping people buy shares in the right companies to cut their inheritance bill. Providers such as Octopus, Canaccord Genuity and Downing run AIM Isas with this purpose in mind.

However, investors interested in this area should beware that firms qualifying for BPR are at the adventurous and therefore riskiest end of the spectrum.

You need to research carefully, and spread your investments so they are not too concentrated in this area and not sufficiently exposed to other assets like large company shares, commercial property, or corporate and government bonds.

This makes BPR a suitable inheritance planning tool for wealthy people, who are either experienced investors themselves or can afford high end financial advice, not the modestly well-off who can’t afford to risk a lot of their investment pot in this sector.

You might come across financial products which offer wealthy savers protection against inheritance tax. 

In all situations, consider the investment case and the risks attached, not just tax.

10) Farming and forestry: Arcane corner of tax law

Even if you are a farmer or landowner, this is the kind of specialist area where you will need professional advice on inheritance planning.

You are allowed to pass on property free of inheritance tax if it qualifies for agricultural relief, which is described by the Government as ‘land or pasture that is used to grow crops or to rear animals intensively’.

But there are strict rules about what is and is not covered – farmhouses are included but farm machinery, livestock and harvested crops are not, for example.

And to qualify, the property must have been held and occupied for at least two years by the owner or their spouse, or seven years by someone else, and be part of a working farm in the UK or European Economic Area.

Meanwhile, people who own woodland can get full BPR from inheritance tax if it has been owned for two years and is commercially managed.

They can also qualify for woodland relief, which defers inheritance tax – perhaps indefinitely – on the value of growing timber until it is felled and sold.

Check the Government rules on inheritance tax and farmed land. It advises people to contact the inheritance tax and probate helpline if their estate includes a farm or woodland.