Six ways to avoid inheritance tax

If you have never thought that you were rich enough to pay inheritance tax (IHT), think again. As property prices have increased, particularly in the south-east, outstripping general inflation, even homeowners with modest incomes are beginning to worry about the impact of tax on their family's fortunes when they are gone.

This year Government revenue from inheritance tax, which is levied at a flat rate of 40% on a deceased person's assets over a certain value, is expected to hit £3.4 billion, mainly as a result of the steep increase in house prices, which have on average risen by 176% over the past decade.

This figure contrasts sharply with that of the threshold at which tax is payable - "the nil rate band" - which has been lifted by a mere 85% over the same period. This means that many more families are being caught in the inheritance tax net.

The avoidance of inheritance tax is something of an industry, with accountants and tax planners devising ever more devious - legal - schemes to help their clients avoid paying up. But, without going into the realms of complicated trusts and other wheezes, there are a number of simple steps you can take to avoid the tax.

Understand the IHT problem

Unfortunately you can't just give away everything on your deathbed to avoid the tax. IHT is due on the value not only of what you own at the time of your death, but also may be due on things you have given away during your lifetime. This can include money, shares, your home, jewellery and artworks, or anything else of value.

Nil sum gains

An initial slice of what you own - known as the nil rate band - is not liable to tax. This year the nil rate band is £285,000. The figure, which rises roughly in line with inflation, will be £312,000 by 2008. If everything that you own is worth less than the nil rate band you have no tax to pay.

There is no inheritance tax to pay where everything is left to a spouse or civil partner. However, leaving everything to a partner could compound the tax problem on the death of the second partner.

One of the ways married couples can save tax is changing the way they own their home. Most married couples own their home as joint tenants (a legal term describing property ownership, and nothing to do with renting). As joint tenants, both partners own the whole house together, and when one partner dies the house automatically goes to the survivor, without the need for probate.

If you change the way you own your home to that of tenants in common, where each party owns half of the property outright, they can make use of the nil rate band and pass their share to whomever they please - including children, grandchildren or a trust. However, this course of action is fraught with complications, so anyone doing it needs to consider the consequences carefully, with the help of a tax planning expert.

Something's got to give

You are allowed to give away some of your cash each year and avoid tax:

• Annual gift allowance: You can give away £3,000 each year and this money is taken out of the tax net. Unused allowances from the previous year can be brought forward to the current year, allowing you to give away up to £6,000 tax-free. But you cannot carry forward allowances for more than one year.
• Small gifts: You can give any number of gifts up to £250.
• Wedding gifts: You maygive each of your children up to £5,000 when they get married or enter a civil partnership £2,500 to grandchildren without attracting tax. Other relatives and friends can receive up to £1,000 on the same basis.
• Party time: If you are trying to minimise your tax burden, and are blaming the Treasury for all your woes, you may not feel like giving Gordon Brown any more money. However, if you want to support the Labour Party - or indeed any other political party - you can give it as much as you like completely free of inheritance tax. The same rule applies for registered charities, which include among their number TaxAid, a charity providing free tax advice to people who cannot afford to pay a professional adviser.

Give away PETS, don't keep them!

If you want to give away larger sums, you mustn't die straight away if you are to escape tax! Assets given away that don't fall into other tax-free categories become "potentially exempt transfers" or PETs. They are called "potentially exempt" because they become fully exempt from tax if you survive for seven years after making the gift.

However, if you die within seven years, you do not pay the full 40% tax. So-called "taper relief" can reduce the amount of tax payable to 80% of the total that would be otherwise due after three years, 6% after four, 40% after five and 20% after six years.

Regular gifts from income

If you have a comfortable standard of living you may give away as much as you like from your income - but not capital or assets. This money could be a straight cash gift, or it could be used to fund certain types of insurance policy. A typical example could be a "whole of life" insurance policy, which pays out when you die, with the payout used to pay the IHT bill, thereby keeping your estate intact (particularly useful for people who don't want their house to be sold to pay a tax bill).

A gift out of income could also fund contributions into a child trust fund, or contributions to a stakeholder pension for the benefit of a grandchild.

Pension planning for a child may not seem an obvious choice, with the young persons retirement 50 or more years ahead. But not only is it helping a child to get a head start in the pension stakes, bu,t as well as potentially saving IHT, a contribution of just £2,808 a year gets topped up with basic-rate tax relief to £3,600, making it a very tax efficient type of investment.

You can't have your cake and give it away

One final word of warning: you can't give something away and continue to benefit from it. For instance, you can't give away your home and continue to live in it (unless you pay the person you gave it to a full market rent). You can't give away the family portraits and continue to have them hanging on the wall. If you do this the gift is called a "gift with reservation" and is fully taxable, as if it had never been given away.

Anyone entering into any arrangement to avoid tax should remember that IHT planning is an extremely complicated subject, and effective legal avoidance needs advice from a qualified estates practitioner.

18 July 2006 © Moneyextra.com

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