Economy

If you’re rushing to beat Rachel Reeves’ inheritance tax raid and protect your wealth you must read this. These are the costly hidden pitfalls experts say you need to know about

The threat of another inheritance tax raid could goad growing numbers of people into making generous gifts to loved ones before the taxman can swipe their family wealth. A race is already under way to hand cash and assets to younger generations before unspent pensions fall into the tax net from April 2027.

Now there are rumours that Chancellor Rachel Reeves is considering a further raid, this time on gifting, to fill a black hole in the country’s finances.

Options could include imposing a lifetime cap on what you can give away without incurring death duties, and increasing the number of years that you must live after making a gift for it to be free of inheritance tax from seven to ten.

Making gifts is one of the simplest ways to reduce an inheritance tax (IHT) bill, because if you live for at least seven years they become exempt – and there are a number of gifts you can make every year with no tax risk at all.

Wealth managers say many people are taking advantage of the gifting rules to give away wealth sooner rather than later.

While lawyers say more clients are updating wills with a view to avoiding inheritance tax.

There are rumours that Chancellor Rachel Reeves is considering a raid on gifting to fill a black hole in the country’s finances

However, a spike in pension withdrawals that showed up in recent tax data is likely to have been driven in part by people panicked into rash moves ahead of the 2027 deadline, such as giving away too much to their children and grandchildren too soon. And many more could be pushed into action by fears of new gift restrictions.

As a result, inheritance experts are urging people to consider their next steps carefully in case decisions made with the best of intentions end up backfiring on them – or even their loved ones.

So to safeguard your finances, beware the following pitfalls.

Don’t worry needlessly

Do not pursue elaborate inheritance tax avoidance strategies unless you are certain your estate is big enough to be slapped with the dreaded 40 per cent levy.

Many well-off people are sure they know how IHT works, but most are kidding themselves, according to recent research by Charles Stanley among those with above average salaries and at least £1,000 in cash savings.

About half with estates worth less than the main threshold thought they would have to pay IHT, and expected a bill running into tens of thousands of pounds, which they would never face in reality.

Essentially, you need to be worth £325,000 if you are single, or £650,000 jointly if you are married or in a civil partnership, for your loved ones to have to stump up IHT. This basic threshold is called the ‘nil rate band’.

But there is a further chunky allowance of £175,000 per person, known as the ‘residence nil rate band’, which increases the threshold to a joint £1 million if you have a partner, own a property and – crucially – leave money to your direct descendants, such as children or grandchildren.

Do not pursue elaborate inheritance tax avoidance strategies unless you are certain your estate is big enough to be slapped with the dreaded 40 per cent levy

Do not pursue elaborate inheritance tax avoidance strategies unless you are certain your estate is big enough to be slapped with the dreaded 40 per cent levy

‘IHT is for the most part a “cliff edge” tax,’ says Rob Morgan, chief investment analyst at Charles Stanley. People without children can end up paying a lot if they are leaving money to nieces and nephews or siblings.

‘For a single person with no eligible family home the relevant figure is just £325,000,’ he says.

‘The bill can quickly ramp up as the size of an estate increases beyond that threshold.

‘The relevant nil rate band changes with circumstances.’

If you are worried about your pension savings bumping you above the IHT threshold if you die after April 2027 when the rules change, remember that it is only the unused portion that will count. Most people spend down their pots significantly during retirement.

Beware giving too much

It might be tempting to gift lavishly to family members now if you think the taxman will be breathing down their necks after you’re gone. But no one knows how long they will live, or their precise needs as they age.

You could risk giving away more than you can afford – or needlessly paying income tax if you’re taking money from your pension to pass it on to loved ones.

Pete Fairchild, head of private clients at consultancy firm Crowe, says he is seeing more lifetime giving from people who expect to live seven years to reduce the IHT on their estate.

He says: ‘Many clients have taken their 25 per cent tax-free lump sum from their pension and gifted that immediately to their children.’

However, once you have taken this lump sum, all further pension withdrawals are treated as income and may attract income tax.

Daniel Hough at wealth manager RBC Brewin Dolphin says a lot of basic rate taxpayers would rather pay 20 per cent income tax to withdraw cash from their pension to pass on to loved ones now in the hope that it saves them from a 40 per cent IHT bill later.

However, some are making big pension withdrawals to pass on wealth now that are pushing them above the higher rate income tax threshold of £50,271, he adds. And in extreme cases, they are taking cash right up to the additional rate threshold of £125,140 to gift large sums to their family, he says.

Withdrawals at the higher rate threshold could lead to a 40 per cent income tax bill – which is the same as the IHT bill.

Gifting early may make sense in some circumstances. If you die when you are 75 or over, loved ones may also have to pay income tax to withdraw cash from a pension they inherit from you.

However, the rules are complicated and nuanced so it is best to seek professional advice.

Pensions will only be treated as part of estates for IHT from April 2027, so some advisers are suggesting clients wait until then before deciding whether to act.

Don’t sit on the fence

Do not think that if you have given something away that you can carry on enjoying use of it yourself. If HMRC deems it a ‘gift with reservation of benefit’ then IHT is still payable.

If you give away a painting, a piece of jewellery or a classic car, for example, make sure that the new owner takes it immediately, and that they insure it, not you.

Even if you have legally handed over ownership, HMRC may still consider you haven’t really made a gift if it’s still in your possession.

Debra Burton, a partner at Lime Solicitors, adds that giving assets away immediately before death to try to reduce the value of an estate simply doesn’t work.

‘HMRC looks back at the seven years before death and takes into account any gifts made during that period. They reduce the available nil rate band,’ she says. ‘Similarly, giving assets away and then continuing to use them, for example transferring the house to a child and still living there.’ 

Remember your will

Try not to fall into the trap of focusing on gifting during your lifetime and forgetting to consider the IHT implications of your will. Spouses inherit free of inheritance tax, so you can leave more or all of your estate to them instead of your children to delay and minimise the eventual bill.

You can also pass money direct to grandchildren to avoid incurring IHT twice over, after a grandparent’s and a parent’s deaths, explains Nicola Waldman, a lawyer at Hodge Jones & Allen.

To take a broad example, if you passed on wealth to your child and the portion of your estate above your IHT threshold was £2million, a 40 per cent bill would be £800,000, she says.

If, more than five years on, the remaining £1.2 million remained unspent and was then passed on to a grandchild, the estate would be taxed £480,000 and the grandchild would receive just £720,000.

However, if the grandparent had left the money direct to the grandchild, the estate would have paid £800,000 in IHT and the grandchild could have got £1.2 million.

Lawyers tell us some people are already making changes to wills, but if someone dies intestate or with a will that is disadvantageous for IHT, beneficiaries can change this with a ‘deed of variation’.

‘There is a strict two-year time limit to get the potential tax advantages, so it is important to get the document prepared and signed in time,’ says Waldman. ‘Once made they cannot be changed. A variation can only be made once in respect of a particular asset in the estate.’

Finally, don’t cause a family rift by being so focused on reducing IHT that some relatives feel unfairly treated under your will.

Consider care fees

IF YOU you are making large gifts, make sure you have enough left to cover your own costs for the rest of your lifetime.

Hough points out life expectancy for a woman aged 66 is 88, and for a man it is 85. However, there is a chance you may live considerably longer than that.

‘There is a fine line between passing down wealth as efficiently as possible and enjoying a comfortable retirement,’ he says.

Care home fees are colossal and rack up fast.

You are likely to have to cover your own costs if you have more than £23,250 in assets in England. Other parts of the UK have different rules.

However, if your local authority has to step in to pay, it will carry out a financial assessment. If it deems that you are unable to pay your care bills because you gave away wealth to loved ones, it can claw back the money.

‘They can investigate gifts or asset transfers to determine if there was what is known as a “deliberate deprivation of assets” intentionally reducing wealth to avoid care charges,’ warns Michelle Evans, a solicitor at law firm Hugh James.

‘Unlike IHT, there’s no time limit on how far back they can look, though actions taken shortly before applying for care support are more likely to be challenged. Timing and intent are crucial.’

If an authority decides against you, it will treat you as still owning the money or assets you gave away and charge you accordingly.

Evans says estate planning is legal, but warns she is seeing increasing scrutiny from local authorities given their current budget constraints.

Fully document any asset transfer to mitigate IHT and seek legal advice, she suggests.

Always keep records

If you are making gifts to avoid IHT, don’t give your loved ones a big headache by not keeping a good record as you go along.

Fail to do so, and executors will have to do the detective work on your bank statements, and contact family members who might have received gifts to get corroborating evidence from their bank records.

Sketchy information and guessed figures might even mean HMRC opens an enquiry into your estate.

Experts suggest making a written or digital record of gifts, especially any worth over £250 to one person a year, and keeping it with your will. Each time, list what you gave, its value, the date of the gift, and to whom it was given.

You need to keep even better records if you are gifting out of surplus income, to prove you could afford it and there was a pattern of giving.

Check the IHT403 form, which executors use to declare gifts after a death, to find out what information will be required.

Even when an estate is not big enough to pay death duties, a deceased person’s finances need to be gone through – often information must be submitted to HMRC just to prove they are exempt. 

Don’t shun pension pot

It is unwise to be deterred from saving too much into a pension out of concern over IHT. You get a big boost from employer contributions and tax relief, so you would be throwing away ‘free money’ if you are still saving for retirement.

The Government’s decision to include pensions for IHT might mean pension contributions plateau or decline, according to Adrian Murphy, head of Murphy Wealth. But he says: ‘Pensions are still the most effective way to save for retirement and savers should be encouraged to continue to contribute whatever they can afford to.’

Ian Cook at investment manager Quilter Cheviot says of the Government’s move: ‘It’s a disincentive for people to save for the long term. The message it gives to the wider public is: don’t save into your pension, which is wrong.’

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