HMRC prepares for a windfall as Britons are at a loss dealing with IHT

When it comes to taxes, not even death stops the taxman from collecting. Once seen as tax targeting the rich, rising house prices have dragged thousands more into the IHT net, leading to a record £5.2bn haul for HMRC in 2017/2018.

With inheritance tax, advanced planning could save you up to 40%. If you are not fond about the idea of HMRC receiving a large chunk of your estate when you die, Pedro Gonçalves explains what steps can be taken to prevent this.

This March, HMRC reported a staggering 44.4% increase in inheritance tax (IHT) receipts to £5.4bn, compared to the previous month. That's up £200m on the previous year and £600m more than the £4.8bn collected in the year ending April 2017.

This represents a new high in terms of annual revenue for the government and as a proportion of the GDP.

However, the figure is predicted to soar in the next years as increasing numbers of middle-class, home-owning families find themselves swept into the tax-paying threshold. HMRC is preparing for a windfall with estimates that death taxes are set to double to £10bn by 2030.

"Taking money from a grieving family who are burdened with the loss of a loved one and sorting their affairs, sounds like something a villain from a Dickensian novel would do. Unfortunately, it's a very real activity in the modern day and one that is reaping more and more revenue for the government," Rachael Griffin, tax and financial planning expert at Quilter, said.

Canada Life wealth management and tax specialist Neil Jones argued a lot of the payments were preventable, explaining: "Death and taxes may be the only two certainties in life but, with careful planning around the former, some of the latter is unnecessary.

"Starting any planning early is essential and there are a range of trusts available that can enable clients to make sure more of their money goes to beneficiaries while reducing the amount of tax payable when they die."

Sarah Coles, personal finance analyst at Hargreaves Lansdown added: "In many cases the taxman hasn't had to increase taxes in order to take more of our money. He just waits for our incomes to rise and asset values to increase, and he's set for a tax bonanza.

"Given that the taxman is so skilled in the art of taking as much of your money as possible, it's up to us to ensure we're not paying more than our fair share. It's essential we take advantage of as much of our allowances as we can, from ISAs and LISAs to pensions. So, you can enjoy the fruits of your labours, without the taxman taking a bite."

Advance planning could save up to 40% on death duties. As taxpayers paid a total of £5.2bn in IHT in 2017-18 around £2bn could have been saved with the right advice to navigate the IHT rules. This amounts to £81,600 if an estate is eligible for IHT.

It is perhaps one of the most prevalent misconceptions about financial advice - that individuals need a significant amount of assets before seeking the advice of an estate planning adviser becomes worthwhile. 

MILLIONAIRES ARE NOT THE ONLY ONES PAYING DEATH TAXES

Gone are the days when inheritance tax was only a concern for the wealthy. Huge numbers of middle-class people in London and the South East are being hit by inheritance tax, even though it was meant to hit the super-rich.

Rising property prices combined with a freeze on the inheritance tax allowance has led to the number of properties qualifying for the costly tax - homes valued at £325,000-plus - to increase by 50% over the past five years.

In the UK, when you die, the government assesses how much your estate is worth. It then deducts your debts from this to give the value of your estate.

Assets include any cash in the bank, investments, properties or businesses owned, vehicles and payouts from life insurance policies. Your estate will owe tax at 40% on anything above the £325,000 inheritance tax threshold.

Inheritance tax is one of the most controversial fiscal policies. Some countries simply do not apply it. The idea is that without it you perpetuate inherited wealth, so the rich stay rich generation after generation.

Inheritance tax aims to redistribute income so some of the money goes to the state to be distributed for the benefit of all. Critics argue that when money is earned, tax is paid at the time, so with inheritance tax you are actually paying tax a second time.

Critics are also keen to highlight that the UK's wealthiest individuals and families with the largest estates on death are paying half the effective inheritance tax (IHT) rate of many smaller estates.

With house prices - usually someone's most valuable asset - increasing over the years, many more people that would not be considered rich have been caught by the inheritance tax threshold.

To tackle this, the government revealed in 2015 that this duty would be scrapped when parents or grandparents pass on a home worth up to £1m (£500,000 for singles). This is being introduced gradually until April 2020.

However, it is not as straightforward as it seems. The current allowance whereby no inheritance tax is charged is on the first £325,000 (per person) of someone's estate. Couples can leave a home worth £650,000 without it attracting inheritance tax (singles £325,000). Above the threshold, the charge is 40%. This remains unchanged. What has changed is the introduction of a residence inheritance tax (IHT) nil rate band (RNRB)

Launched in the 2017/18 tax year this residence allowance is only valid on a main residence and where the recipient of a home is a direct descendant (as children, step-children and grandchildren). This is gradually being phased in and is what you will get on top of your existing allowance.

This additional allowance gave homeowners an extra £125,000 when passing their house to their children or grandchildren. This RNRB rose to £150,000 for 2019/2020 and will rise to £175,000 in 2020/2021, after which it will rise in line with inflation.

At its simplest, in 2020/21 when the full RNRB is in play, a married couple would not pay IHT on £325,000 + £175,000 = £500,000 x 2 spouses = £1m where the RNRB applies.

On properties worth between £1m and £2m, inheritance tax will be paid as normal on the amount above the tax-free amount.

For the tax year 2019/20 everyone is entitled to leave an estate valued at up to £325,000 plus the main residence band of £150,000 giving a total allowance of £475,000. For estates under this the beneficiaries will not pay any inheritance tax.

If you leave behind assets worth £500,000, your estate pays nothing on the first £475,000 and 40% on the remaining £25,000. A total of £10,000 in tax if you are not leaving anything to charity.

For the above example, all sums double in the case of a married couple or in a civil partnership.

HOW TO SAVE THOUSANDS IN INHERITANCE TAX

Inheritance tax can cost hundreds of thousands in the event of your death, yet it's possible to legally avoid huge swathes of it, or possibly pay none at all.

Gifting assets. Transfers of assets to younger relatives made seven years or more before death are not usually taxed. So, anyone who has a buy-to-let property, for example, can put it in the name of one of their children, if they do not need the income from it to support their retirement, in enough time for the seven-year exemption to apply.

Gifting money. Beyond property, you can give cash or shares to your family at least seven years before you die.

Buying AIM shares. The UK government has attempted to use the tax system to subsidise investment in businesses that would otherwise struggle to raise funding. To this end, it has made shares in companies listed on the Alternative Investment Market (AIM), exempt from inheritance tax when bequeathed.

Trusts. Putting money or assets into a trust can protect it from liability for IHT. The government says that if you die within seven years of a transfer into a trust, the estate will pay the death duty at the full rate of 40%. If a payment is made into a trust during one's lifetime, and you do not die within seven years, a charge of 20% is payable.

All the above solutions were simplified and are not a comprehensive list. It is always worth talking to a specialist about your specific case.

THE NEED FOR PROPER PLANNING

As the middle-class gets caught in the IHT net, the UK's super-rich are paying just half the effective inheritance tax rate of many smaller estates, according to an analysis of HMRC data by Canada life.

The figures, provided as part of a freedom of information request, show that estates worth £10m or more pay 10% IHT on average, around half the rate paid (20%) paid by estates worth between £2m and £3m.

The difference is down to what it calls ‘deep inconsistencies' in the way different assets are taxed for inheritance purposes, which in turn leads to similarly sized estates paying significantly different rates of tax.  

According to the analysis, the main reason for this is the fundamentally different asset composition for estates of different sizes. Larger estates typically have a much smaller percentage of their value in UK residential property (10%), which does not have high levels of tax efficient exemptions, and a much higher amount in securities (40%) which can attract 100% tax relief.

Neil Jones, from Canada Life, said: "This difference in the net tax rates paid by estate isn't always down to the value of the estate or the different type of assets held in an estate.

"It's often about a willingness to plan.

"There is a myriad of potential solutions in an adviser's kitbag to help mitigate IHT and some smaller estates can certainly benefit from these to reduce the tax payable and increase the wealth being passed on to future generations.

"There is also a more fundamental issue of being willing to create an estate planning strategy. It's still somewhat taboo to talk about death and certainly many clients, and even advisers, undoubtedly find it difficult to introduce it, but it needs to be talked about.'

Jones also argued that some aspects of inheritance tax are ripe for reform, pointing out that as it currently stands, some forms of equities bought just two years before death attract 100% inheritance tax relief.

"In our view, IHT needs to be simplified. The basic principle is simple however the piecemeal nature of the regulations can make it an uneven playing field. It will be interesting to see the second paper from the Office of Tax Simplification, looking at reliefs, when it is released in the spring and what it recommends," he said. 

Families have also been caught sleeping on inheritance tax as they postpone seeking financial advice.

The lack of awareness around IHT in the UK has increased in the last year, with half (50%) of liable over-45s admitting to be unaware their main property could be subject to IHT.

According to Canada Life's latest edition of its annual report on IHT, the proportion unaware their main property may be subject to IHT has risen sharply from a third (36%) a year ago. Canada Life surveyed 1,002 UK citizens, holding assets exceeding £325,000.

The lack of knowledge extends beyond property to other assets. Over three fifths (62%) do not think that their pension savings are subject to IHT, compared to 57% a year ago. Two thirds (66%) are not aware that agricultural land is subject to IHT, a significant increase from 57% last year.

"IHT ignorance is rising at an alarming rate in the UK, and there is no indication that this will stop anytime soon," Jones said.

For Dave Elzas, founder and CEO of Geneva Management Group, it is imperative that there is planning and that Britons use all the tools available to do it properly.

"Ultimately, if you have access to expertise, why not use it? It'll save you worry in the here and now and prevent unnecessary stress for your beneficiaries in the future," he said.

Canada Life figures also show that the majority (71%) of the UK population is unaware of the threshold they are taxed - set at £325,000. Confusion also persists around the nil rate band and the rate at which assets above the threshold are taxed (40%). The percentage who do not know what this rate is has remained broadly the same year-on-year (54% vs 55%). 

Four in five (80%) over-45s believe the current IHT rules are too complicated, up slightly from 77% last year.

In January 2018, the Chancellor ordered a wide-ranging review of the inheritance tax system by the Office of Tax Simplification to investigate whether the current rules create any distortions to taxpayer decisions.

A report presented by the Office of Tax Simplification (OTS) to Parliament in November said Britain's inheritance tax system was "complicated and confusing" and needed to be overhauled dramatically.

Paul Morton, tax director at the OTS, said: "The overall picture we gathered from people's responses is that IHT is seen very much as an administrative burden.

"The overarching point that emerged is that IHT returns must be made even when there is no tax to pay.

"Returns are submitted in relation to about half of all UK deaths, even though IHT is payable on less than 5% of deaths."

The OTS has suggested inheritance tax forms need be simplified, and that the claims process should be moved online to reduce levels of complexity.

Morton added: "The short form, called the IHT100, is only about eight pages long, which is not too bad, but the longer form, the IHT400, is 16 pages long with 92 pages of notes to go with it.

"Wading through all that is going to be quite difficult for a lot of people.

"If it was turned into more of an online tool - which guided people through the process - it would be a lot easier to navigate."

WHAT IF I AM AN EXPAT?

Just because you live abroad does not mean you are exempt from IHT. Unlike any other tax, UK IHT follows you around the world, regardless of where you may reside. That is because it is based on your domicile, not residence. The reason why understanding domicile is an important element of estate planning.

Living outside the UK does not automatically protect you. The basic rule is that a person is domiciled in the country in which they have their home permanently or indefinitely. Therefore, you can live abroad for many years and still remain domiciled in the UK.

Other countries have similar versions of inheritance tax, so depending on where you moved, inheritance tax may be payable twice. Although in most cases the UK would give credit for the tax paid overseas. This is the case for expats in Spain or Portugal. If the HMRC deems you as UK-domiciled, all your foreign assets are liable for IHT.

To acquire a domicile of choice, you must be physically present and a tax resident in your new country, have formed the intention of living there permanently and not foresee a return to the UK. You will also need to sever as many ties as possible with the UK. Even stating that you do wish to be buried in your homeland will count against our case.

It takes at least three years to shed UK domicile for inheritance tax purposes. You will be deemed domiciled in the UK for inheritance tax if you were UK domiciled at any time in the previous three years, or were UK resident for any part of 17 of the last 20 tax years.

A financial adviser will help you establish your domicile status and show you what steps you can take to avoid these taxes for your heirs.

This article was first published earlier this month as part of International Investment's special report on IHT