Unfortunately, more and more people are finding themselves in the position where their assets have reached a value that means their children could face a significant Inheritance Tax liability when they die.


It seems so unfair that we pay tax all our lives on our income at anything up to 40 per cent and yet the taxman can still swallow up another 40 per cent of our assets after we die. Fortunately, Inheritance Tax is one tax that with some careful financial planning can be reduced and in some cases, completely avoided.

Make gifts in your lifetime

You can give up to £3,000 a year from capital in any one year. You can also make wedding gifts of up to £5,000, if you are a parent, or £2,500, if you are a grandparent, and gifts to charities and political parties are exempt.

Although gifts outside these exemptions usually attract Inheritance Tax, there may be a reduction in the tax on a sliding scale if you die within seven years of making the gift. After the seventh year, the gift is deemed to have dropped out of your estate. This is known as a Potentially Exempt Transfer or PET.

This 'seven year ticking clock' only works for an absolute gift where the donor retains no interest or benefit from the asset gifted. If the donor retains an interest or benefit in the item gifted, then it may fall foul of the Gifts with Reservation rules.

For example, many people who have substantial property assets believe that to reduce the potential Inheritance Tax liability on their estate, they can gift their house to their children during their lifetime.

However, if you gift your main residence to your children and you continue to live in the house without paying a normal market rate of rent, the Inland Revenue would deem this to be a Gift With Reservation of Benefit.

In effect, this means the gift would not be recognised and, in the event of your death, the full value of the house would be included in your estate for Inheritance Tax purposes.

Use your wills

Most married couples who make wills, leave their entire estate to each other, so that when one partner dies, the survivor ends up owning everything. Unfortunately, this means that when the spouse dies, their total estate is increasingly likely to be well above the nil rate band. The beneficiaries will therefore pay Inheritance Tax at 40 per cent on anything above £300,000.

By including a Discretionary Trust in each of your wills, you could make use of two nil rate bands, rather than just one and save the tax on £600,000.

On first death, instead of everything being inherited by the spouse, some of the deceased's assets are held in a Discretionary Trust created by their will. Subject to certain rules, the surviving spouse will still have some access to those assets. The assets can be investments or even part of the main residence.

To use a house, you need to have the joint-ownership of your home severed in favour of 'tenants in common' ownership. You would then each effectively own half of the house, rather than owning it jointly and severally. This means that instead of the full value of the house passing to the surviving partner on first death, only half of the property would be owned by the surviving partner. The half of the house owned by the deceased would pass into a trust established by their will.

By using a special IOU clause, the trustees could then effectively 'lend' the half-share of the house in the trust fund to the surviving spouse for the rest of her lifetime. In the event of the death of the spouse, the IOU is called in by the trustees. The half of the house in the trust fund will pass to the ultimate beneficiaries (ie children or grandchildren) outside of the joint estate, with no Inheritance Tax payable on it.

Based upon a property valued at say, £400,000, this would mean that £200,000 worth of the estate would drop into the trust, saving your beneficiaries £80,000 in Inheritance Tax at current rates.

Reader question

Graham, from Sudbury, asks: I have heard you can take out insurance to cover your Inheritance Tax bill. How does this work and is it expensive?

For married couples, this can be a very effective method of providing money to your children, so that they can pay the tax bill after your death. This is usually referred to as a Discounted Inheritance Tax Plan.

Essentially, you apply for a flexible unit linked, whole of life insurance policy, to cover your joint lives on a second death basis, with an initial sum assured equivalent to your identified Inheritance Tax liability.

The policy is written under an absolute trust in favour of your children, so that the proceeds will not form part of your estate on death. In the event of the death of either of you, the policy would not pay out any money. However, when the surviving partner dies, the sum assured is payable from the trust fund and thus outside your estate, to your children. They would then have tax-free funds available with which to pay the Inheritance Tax liability due on your main estate.

This method of funding for Inheritance Tax is called a Discounted Plan because in reality you will never pay the cost of your tax liability into the plan in premiums. You are effectively 'buying' the money for your children to pay the tax bill with at a discount on interest free credit by monthly instalments for the remainder of your lifetimes.