What you need to know about inheritance tax planning

WEALTH taxes have remained high on the political agenda in recent months. After the latest party conferences, it seems increasingly unlikely that we will see any new measures introduced in the immediate future. So, we are left with the UK’s only existing form of wealth tax: inheritance tax (IHT). Rather than being an annual tax on all wealth, IHT is a once in a lifetime levy on what you leave behind after death.

Upon death, all of your assets less liabilities (including any mortgage that you may have), plus anything that you have given away in the last seven years – tapered slightly for gifts made more than five years ago – are added up. Anything you leave to your spouse or civil partner is exempt, and there are also various other exemptions such as legacies to charities. No tax is payable on the first £325,000 of what is left, but there is a 40 per cent tax on any assets above that amount.

For many couples with assets of no more than £1m, for example, the first priority will be to make sure that the surviving spouse is adequately provided for. The natural instinct is to pass everything on to the surviving spouse (exempt from tax) without worrying about the IHT payable on their death. You might think that this course of action would lose out on the £325,000 free of tax on the first death, but there is a special rule that allows you to pass on the tax-free amount to your partner if it is not used on the first death. When the second spouse dies, they have a tax-free amount of £650,000 if none was used when their partner died (or their own £325,000 plus whatever proportion of their partner’s is left).

So how does someone plan to reduce their IHT? The most obvious answer is to give your wealth away to your heirs and then hope that you survive for seven years so that there is no liability. The drawback, of course, is that it may not leave you with enough money to survive on for the rest of your life. If you run out of money, you could end up relying on your heirs (normally your children) to look after you out of what you gave to them earlier. But many older people do not find that very attractive, and there is no point in giving away your main residence as a gift – assuming you still live there ­– as it will not be helpful for IHT if you continue to make use of it.

In practice, people with more wealth tend to pass on what they feel that they will not need in their old age. The cost of IHT falls proportionately greater on individuals and couples with wealth up to £1m or so, and that is the source of the main tax take for the government.

Many people, other than the very rich, end up doing little tax planning for IHT. After all, by the time it comes to be paid, they will not be there to worry about it. Their heirs will still be receiving a gift from the previous generation – even if they themselves have to pay taxes on it.

Patrick Stevens is a tax partner at Ernst & Young