How to avoid inheritance tax traps

The investments, property and possessions that you own are testament to your hard work. It's only natural to want to pass them on to your family one day, so they can have it better than you did.

The best way to make sure your wishes are carried out once you're gone is to write a will. The thinking behind having a clear will is that all your money and assets, which together form your estate, can be distributed among your beneficiaries – so everyone receives exactly what you want them to.

But inheritance tax could potentially stop you from doing that. Without proper planning, your beneficiaries may have to pay a 40% tax on some of what they inherit from you.

But there are simple ways to protect your estate from unnecessary tax charges – unnecessary because they don't have to be paid at all if you steer clear from some inheritance tax traps.

Inheritance tax thresholds

There are two thresholds to be aware of if you want to prevent your beneficiaries having to pay an abundance of tax.

First is the nil-rate band, which stands at £325,000 for the 2022/23 tax year and means an estate with a value below this figure will not see a tax charge at all.Only the value above it will be taxed.

There is also the residence nil-rate band, which applies if you're passing on a family home to direct descendants, such as your children or grandchildren.

This currently stands at £175,000, effectively increasing the amount you can pass on entirely tax-free to £500,000, if your estate includes property.

In addition, married couples and civil partners can inherit each other's estate completely tax-free, meaning a surviving spouse or civil partner could potentially pass on an estate valued at £1 million without a tax being applied.

The gift trap

A lot of estate planning depends on understanding and making use of thresholds and planning accordingly. You can do this by reducing the value of your estate by distributing your assets during your lifetime.

HMRC calls these 'gifts', but there's a catch that could see an inheritance tax charge being applied anyway.

Since 2016, it's cost almost 2,000 people an astonishing £624m cumulatively, just because they might not have fully understood the dangers of the gift trap.

The trap is this: your gift will not be considered as a gift for inheritance tax purposes if you continue to benefit from it after you've given the asset away.

A common example is where someone continues to live in, and therefore benefit from, a property they have gifted to a descendant.

When this happens and HMRC finds out, no tax breaks will apply and the gift will still be considered as part of the gift-giver's estate for inheritance tax purposes.

So, avoid the gift trap by refraining from using gifted assets as if they were still your own.

The seven-year rule

You also need to be aware of the seven-year rule if you're trying to reduce the value of your estate.

Related to gift-giving, it means that gifts of property and other assets can only be tax-free if the person making it lives on for at least another seven years.

While this is a common-sense policy, preventing people from passing on vast sums of money tax-free, it can make estate planning more difficult.

However, it doesn't necessarily mean your gifted assets will be charged at 40% if you die within the seven years after the transfer.

Instead, gifts made three to seven years before the gift-giver dies are taxed on a sliding scale as follows:

  • 3 to 4 years – 32%
  • 4 to 5 years – 24%
  • 5 to 6 years – 16%
  • 6 to 7 years – 8%.

The way to get around the seven-year rule trap is simple: start thinking about your estate planning as soon as possible.

Talk to us about your estate planning to learn about other inheritance tax traps you need to know.

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