How to Reduce Inheritance Tax: Avoid These Costly Mistakes
As inheritance tax receipts reach a staggering £7.1 billion annually, many families are seeking ways to minimize their tax burden. From making gifts during your lifetime to setting up trusts, there are legitimate strategies to pass down wealth without incurring hefty taxes. However, it is crucial to proceed with caution to avoid unexpected tax bills. We have identified eight major pitfalls that you should be aware of when planning your estate’s future and the potential costs they entail.
1. Hand over home and stay in annexe – Risk a £115,000 hit
Parents often want to gift the family home to their children without burdening them with a massive tax bill. Couples can transfer a property worth up to £1 million tax-free to direct descendants, while a single person with children can pass on a tax-free home worth half that amount. Therefore, parents may choose to gift the family home during their lifetime to avoid it being part of their estate for inheritance tax purposes. However, this approach can backfire if not executed correctly.
If you continue to reside in the home after gifting it, it is considered a ‘gift with reservation of benefit.’ Consequently, the property is not deemed a genuine gift and may be included in your estate, subject to inheritance tax. To mitigate this risk, you could consider paying rent to your children if you plan to continue using the property. However, remember to pay market-rate rent, and be aware that your children will need to pay income tax on the rent received.
For instance, if you gift your child a second home and use it regularly for holidays, your family could face a tax bill of approximately £115,000. This calculation assumes you own a primary home worth over £325,000 (or £650,000 as a couple) and a second home valued at the average UK house price of £288,000.
2. Sell up and buy home together – Risk a £27,000 hit
Selling your home and gifting the cash to your children to buy another property does not circumvent the inheritance tax rules. In certain cases, parents sell their home to enable their children to purchase a larger property for the whole family to live together, particularly when caring for an elderly parent. However, this arrangement exposes the family to the risk of an unexpected tax bill.
By allowing the parents to live rent-free in the property, they may fall foul of the ‘reservation of benefit’ rules, resulting in an inheritance tax bill. Alternatively, they could be subject to the ‘pre-owned asset’ legislation, leading to an income tax liability. The latter scenario involves the tax authorities assessing the rental value of the gifted share of the property as part of your income and taxing it accordingly.
For example, suppose you sold your home and provided your child with the funds to purchase a new home where you all live together. In that case, the tax authorities could calculate the rental value of your share, add it to your income, and impose income tax. As per Zoopla, the average UK monthly rent of £1,126 would result in a tax charge of £2,702 annually (higher for those in the higher tax brackets). Over ten years, this amounts to £27,024.
3. Make half-hearted gifts – Risk a £3,500 hit
If you decide to make a gift, ensure that it is done properly and formally. For instance, if you give someone a painting, physically transfer it to the recipient, even if it leaves an unsightly space on your wall. It is crucial to have evidence of the gift, such as adding it to the beneficiary’s home insurance and removing it from yours.
Failing to formalize gifts adequately can lead to investigations by Revenue & Customs, particularly if the gift was made within seven years of the giver’s death. The tax authorities have access to vast amounts of personal information through their Connect database. Ignoring these rules may result in late penalties and interest charges, potentially amounting to significant sums. For example, not paying inheritance tax on a £5,000 painting could cost you £3,505 after five years.
4. Fail to put life cover into trust – Risk a £45,000 hit
Life insurance policies often serve as a means to provide financial support to loved ones after the policyholder’s death. However, failing to set up these policies correctly may subject your beneficiaries to an unnecessary inheritance tax bill. Placing life insurance policies in trust ensures they are not considered part of your estate for inheritance tax purposes.
Surprisingly, nearly 7,000 estates paid inheritance tax on life insurance payouts in the last fiscal year, amounting to £830 million. This suggests that up to £332 million in inheritance tax may have been paid needlessly. By not utilizing trusts, the policy proceeds become part of your estate and may be subject to a 40% inheritance tax charge from the start.
To prevent this, Sean McCann of NFU Mutual advises policyholders to place their life insurance policies in trust, a straightforward process with free trust forms available from many providers.
5. Put pension cash into savings – Risk a £10,000 hit
Pensions offer a tax-efficient method of passing on wealth to family members. If you pass away before the age of 75, pensions can be inherited tax-free. For beneficiaries aged 75 or older, income tax is payable when they withdraw money from the inherited pension funds. Unfortunately, pension holders may inadvertently jeopardize the tax-free status of their pensions by unnecessarily withdrawing money and placing it in savings accounts.
Once pension funds are withdrawn, they are no longer protected from inheritance tax. Pension holders often take advantage of a 25% tax-free lump sum withdrawal from their pension, regardless of their need for the funds. However, this action makes the funds vulnerable to inheritance tax.
For instance, a pension holder who chooses to withdraw and save £100,000 could face a tax bill of £40,000 (assuming a 40% inheritance tax rate). Instead, keeping the funds within the pension ensures they remain tax-efficient and are passed on to beneficiaries without unnecessary tax liability.
By avoiding these common mistakes and seeking expert advice, you can maximize your wealth transfer while minimizing your inheritance tax bill. Proper planning and meticulous attention to detail are paramount to protect your family’s financial future.
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