Tens of thousands of families could escape inheritance tax and many more have their bills slashed under proposals announced by Conservative leader Kemi Badenoch.
Family homes would escape inheritance tax altogether – and there would be a further million-pound allowance, she pledged as she closed the party’s conference in Birmingham.
But what would the rule changes mean for you – and how can you protect your wealth from the taxman under the current rules?
Bold plans: Kemi Badenoch said the Conservatives would scrap inheritance tax on main homes
What are the rules today and what would change?
Under the existing rules, inheritance tax is charged at 40 per cent on estates above the tax-free threshold of £325,000, known as the nil rate band.
An estate is the total value of the wealth, property and possessions of someone who dies, minus any outstanding debts.
An extra residence nil rate band of £175,000 is available against the value of your home if it is passed on to a direct descendant, which must be a child or grandchild (including stepchildren by marriage, or those fostered or adopted).
The residence nil rate band is tapered away for estates above £2 million at a rate of £1 for every £2 above the threshold.
There is no IHT charged on assets left to spouses and civil partners. Married couples and civil partners can pass their unused allowances to each other, effectively doubling them up to a maximum of £1 million.
The residence nil rate band was introduced in 2017 and was designed to make it possible for couples to pass on their family home to direct descendants free of inheritance tax.
However, the allowance has never been raised and house price growth since then means that growing numbers exceed the £1 million threshold and incur a bill.
Under Mrs Badenoch’s plans, all family homes would be free of inheritance tax – and there would be a further million-pound allowance on top of that.
‘No stamp duty when you buy your home, no mansion tax when you live in your home and no inheritance tax on your home when you pass it to your children or grandchildren,’ she said.
Mrs Badenoch added that the move would cut the number of estates that pay the levy in half and that it remained her ambition to abolish inheritance tax as soon as it can be afforded.
Although details have yet to be revealed, it is possible the £1 million allowance for couples could be implemented by increasing the nil rate band to £500,000.
Early estimates by Oxford Economics suggest that this combined with a full exemption on inheritance tax for family homes could result in £6.6 billion less inheritance tax paid in 2029-30.
In the meantime, there are worries that the first Budget under Andy Burnham’s premiership later this month could stage a further raid on wealth.
Although it is unlikely that inheritance tax will be targeted, it is not out of the question as he and Chancellor John Healey look to boost the Government’s coffers.
Even if the Budget leaves IHT alone, you need to know where you stand and undertake some sensible financial planning to avoid a bill.
Of those who pay inheritance tax, the average bill is currently £231,000. At the moment, you would hit this figure if, for example, your home is worth £1 million, and you have £400,000 remaining in pension pots, £125,000 in joint savings and investments, and two cars and personal possessions worth £52,500.
Under Badenoch’s proposals, you would incur no inheritance tax at all with this level of wealth.
Watch out for a pensions overhaul
Unspent pension pots are set to become liable for inheritance tax in a colossal new grab on passed on wealth.
This will come into effect in April 2027. Mrs Badenoch did not comment on whether she would reverse this change if she came into power – and unless a general election is held before then it is all but certain it will come into force.
Prudent savers who built up retirement pots through their working lives will soon see anything left over at death that breaches the IHT thresholds taxed at 40 per cent.
Just one in 20 estates in the 2023/24 tax year were landed with an IHT bill, according to the most recent HMRC figures. This will jump towards one in ten estates when pension pots become part of its scope.
In a painful twist, there will also be double taxation. If a person over 75 leaves a pension pot, beneficiaries pay income tax on withdrawals. From April these pots will be hit twice – once with 40 per cent IHT and again with income tax when money is taken out.
If a pension beneficiary is a higher rate taxpayer – and any meaningful withdrawal would push most into the 40 per cent tax bracket – the effective tax rate will be 62 per cent.
The rule change has radically affected inheritance planning.
Where advisers previously suggested people should try to spend any surplus pension pots last, as they were not part of their estate for IHT purposes, they now say many may be wise to pass them on as tax-efficiently as possible early on.
Michelle Holgate, director at RBC Wealth Management, says: ‘The changes have meant pretty much every client has had to alter their plans in some way, whether that’s bringing things forward from a gifting perspective or re-evaluating how they’re going to draw pensions.
‘The whole planning spectrum has been turned on its head.’
On its head: Pensions will be brought into inheritance tax from 2027, leaving some people’s retirement plans up in the air. Badenoch did not comment on whether she would reverse this
How to beat IHT
The simplest ways to get your potential IHT bill down are to spend your money or give it away. Should Mrs Badenoch’s proposals come into force, the need for action will be dramatically reduced.
However, there are still scenarios where older family members prefer to pass on wealth during their lifetimes, for example to help out the younger generations at a time when they really need it.
Holgate says: ‘The easiest way to give money away from an inheritance tax perspective is to give it directly to an individual. But sometimes people are hesitant to do that. It is a family discussion that we encourage people to have.’
Complicated inheritance strategies, such as trusts and life insurance, require professional financial advice. But even if you take the simpler option of trying to spend or give money away, it is worth considering getting a professional to help.
Have you got a will?
Before you do any planning, you will need to work out what your estate is worth.
That means totting up the value of your home, savings, investments, pensions, any second properties or other assets, and your personal possessions.
You will then know your number and can think about how to plan accordingly.
At this point, you also need to ensure you have a valid will and lasting power of attorney. This is essential even if you have no reason to worry about inheritance tax.
You should also make sure any life insurance policies are written in trust, which will mean they sit outside of your estate and can be paid out immediately rather than waiting for probate to be completed.
Give it away… bit by bit
To stop people handing over all their wealth on their deathbed to dodge tax, there are rules on how much you are allowed to give away each year before gifts become liable for IHT.
Unfortunately, these outdated limits have not been raised since the 1980s. You can give away just £3,000 per year and make unlimited small gifts worth up to £250 per individual. An extra allowance applies for weddings, whereby a parent can give £5,000 or a grandparent £2,500.
Sean McCann, chartered financial planner at NFU Mutual, says: ‘The freeze on allowances means families are being painted into an increasingly tight corner when it comes to inheritance tax planning.’
However, it is vital to remember that these stingy allowances are not a cap. You can hand more over much than this if you want to, but gifts will fall under the so-called seven year rule.
These are known as ‘potentially exempt transfer’ gifts, and if you survive seven years after making them they will become free of IHT. If you die before the seven-year period is up, IHT is paid by the recipient on a sliding scale down to 8 per cent in the final year.
It pays for those who have a large potential IHT liability to make gifts as early as possible while they are in good health.
You need to make sure you leave yourself enough money to enjoy a decent retirement and consider setting funds aside for future care costs. Financial advisers will do a process called cash flow modelling and map out scenarios to help you with this. It is vitally important that you also keep good records of gifts you have made: how much, who to and when.
This will help your executors when it comes to doing probate and be of immense assistance if they are challenged by HMRC.
Using surplus income
A little-known exemption can help you sidestep IHT on gifts.
Commonly known as ‘gifting out of surplus income’ and officially referred to as ‘normal expenditure out of income’, this allows money to be passed on without falling under the seven-year rule.
Gifts must meet some tight criteria and be part of a pattern, but if you can take advantage of this then your IHT-beating strategy can be turbo-boosted.
To qualify, gifts must form part of your normal expenditure, be made out of your income rather than your capital and leave you with enough income to maintain your normal standard of living.
The good news is that pension withdrawals count as income, not capital, and this is proving to be an increasingly popular way for people to run down surplus pension pots and give away their money.
But gifting from surplus income is an area where it can be easy to fall foul of the rules.
It requires excellent record keeping, ideally alongside notes on your intention, and those considering using it should take financial advice.
Holgate says: ‘I often suggest to clients that they complete [HMRC’s] IHT 403 form prior to giving any gifts from regular income, to show what their income and expenditure was, to show that it’s habitual and that they’re meeting those rules.’
Talk to your family
Successfully beating IHT not only requires keeping good records but talking to your family about a difficult subject – both things many of us are not good at.
Often there may be a situation where the younger generation is eager for an early inheritance that could make a real difference to them as first-time buyers, home movers hoping to climb the ladder, or parents struggling with a mountain of bills.
Making gifts in your lifetime offers the opportunity to enjoy seeing your loved ones benefit.
You could get precious moments such as dinners in a first flat or visits to a grandchild at university whose fees you helped cover.
Getting complicated…
There is a selection of more elaborate IHT strategies, ranging from trusts to specialist investments and whole-of-life insurance.
There are consequences if they are not done correctly, and this can be expensive. It is important to seek trusted and independent financial advice.
Also, ask yourself the question: ‘Would it be easier just to spend or give the money away?’
Be diligent: Beating inheritance tax requires keeping good records – and talking to your family
Trusts
These can help people avoid IHT and keep some control of assets, but they are not the magic inheritance tax-beating tool they are popularly believed to be.
Trusts allow you to set aside money, property or investments for someone else – and the seven-year rule applies.
The simplest form is a bare trust, which allows trustees to manage assets until a beneficiary reaches adulthood. The person giving away assets retains no control over them.
In contrast, discretionary trusts give the trustees control over how and when income and assets are given to the beneficiaries – but these come with a charge.
Every seven years you can transfer up to £325,000 per individual into a discretionary trust IHT-free, but every ten years there is a 6 per cent tax charge on the excess over the nil rate band.
Loan trusts involve lending money to the trust, which can be recalled at any time.
This can help those who are worried they may need money in future for care costs.
Tax expert Heather Rogers says: ‘If you are planning to set up a trust, make sure you understand what it will achieve and all the tax implications as well as reporting implications. Beware of mis-selling with trusts – always use a solicitor, specialist accountant or a financial planner.’
Investment schemes
There are some types of investment where the Government offers IHT incentives in return for investors backing smaller and riskier companies.
This includes qualifying firms on the junior Alternative Investment Market (Aim), where investors can get 50 per cent IHT relief if they hold shares in firms with business property relief status for at least two years. This reduces the effective IHT rate to 20 per cent.
These investment schemes are risky, and can be expensive, so independent financial advice and a keen eye on costs is essential.
Whole-of-life insurance
Advisers report a sizeable uptick in the number of people taking out whole-of-life insurance to cover a projected inheritance tax bill.
If you put the policy into trust, it sits outside of your estate and can pay out immediately to a family member who can use it to settle an IHT bill, which must be done before probate can be granted.
Whole-of-life insurance pays out at whatever age you die, as long as premiums and conditions are met. This means that premiums are high – particularly for plans taken out in later life.
Passing on inheritance
The typical age to get an inheritance is 55 to 64, according to the ONS. This means people can end up receiving money that they may not need at that life stage – and which could make their own IHT position worse.
It is possible to legally redirect the inheritance so that you don’t receive it if you act within two years of death.
You can use a deed of variation to pass on an inheritance, in part or outright. Often, this may be done by parents who reroute their own inheritance down to the next generation.
The initial bequest itself may still attract IHT but you will not see your own wealth swell and then be subject to the seven-year rule if you pass on the money yourself.
Farms and businesses
Agricultural Property Relief and Business Property Relief have allowed farms and qualifying businesses or shares to be passed on free of IHT.
But from April the 100 per cent relief was capped at £1 million for businesses and £2.5 million for farms. After this only 50 per cent relief is granted, meaning a 20 per cent IHT rate.
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