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How to avoid inheritance tax

There are a number of ways of helping your heirs avoid having to pay inheritance tax altogether.

In this article
How to avoid inheritance tax (IHT) with gifts How to reduce your estate using equity release How life insurance and inheritance tax works Can I reduce inheritance tax with a 'deed of variation'?

How to avoid inheritance tax (IHT) with gifts

One of the simplest things you can do to avoid paying inheritance tax (IHT) is to spend or give away part of your wealth during your lifetime.

There are several types of gift you can make during your lifetime that are completely free of inheritance tax.

Other gifts you make during your lifetime which don’t immediately fall into the tax-free list may become tax-free, providing you survive for seven years after making the gift. 

These are known as potentially exempt transfers or PETs. Most gifts you make to people (as opposed to trusts or companies) fall into the PET category. 

For more on tax-free gifts and PETs, see inheritance tax planning and tax-free gifts.


How to reduce your estate using equity release

If all your wealth is tied up in your property, you may not be able to make use of gifts during your lifetime or spend your wealth on yourself. To get around this, some people take out an equity release scheme

It's important to remember that this works by reducing your liability towards HMRC by increasing the debts you'll owe your mortgage provider.  

How equity release schemes work

With these schemes you can either borrow money against the value of your home (known as a lifetime mortgage), or sell part of your home at a reduced market rate, but remain living there throughout your life (a home reversion scheme).

The money you release can be passed onto your heirs, or spent yourself, and, providing you survive the gift by seven years, there will be no tax to pay. 

When you die

When you die, the value of your estate will be reduced by the mortgage debt (with a lifetime mortgage) or because only part of the value of your home will still belong to your estate (with a home reversion). 

Think carefully

It sounds simple enough, but think carefully before going down this route. With lifetime mortgages interest is ‘rolled up’ and your debt can swiftly grow. 

For example, a £50,000 mortgage with an interest rate of 7% a year will have almost doubled to £98,358 within 10 years. You could end up owing more to your lender than your estate would have paid in tax – either way, your heirs won’t get that interest.

With the other route, you're selling off part of your home for less than its full value. So think about whether you're willing to let the bank take half of your home, just to stop HMRC getting a slice.

Consult a specialist

If you do think equity release might be for you, we recommend that you always consult an independent financial adviser that specialises in equity release before going ahead.

How life insurance and inheritance tax works

If you can’t beat an IHT bill, you can insure against it. This is one of the simplest ways of covering an unwelcome bill, but unless you're relatively young and healthy, the cost may be high.

However, if it’s too expensive, you can get your children or heirs to pay the premiums – after all, they will be the ones to benefit from the insurance.

How does it work? 

You take out an insurance policy called a ‘whole of life’ policy. If you are a couple, you should normally take out a policy that pays out when the second partner dies. 

The policy is written under trust for your heirs (see above). The insurance company will provide the trust form. 

The idea is to take out a policy that will pay out enough to cover the IHT bill.

Because the policy is written under trust, it's paid out free of inheritance tax and before probate is granted, so your heirs can pay the tax bill as soon as it’s due. 

HMRC treats the premiums paid to the insurance policy as a lifetime gift if you pay them yourself, but these can usually be covered by one of the tax-free exemptions – either the annual £3,000 exemption or the ‘gifts out of normal income’ exemption. 

Put your life insurance in trust

If you have life insurance that you specifically want to be paid to your heirs after your death, then always put the policy under trust. 

Policies under trust don’t count towards your estate when the IHT bill has to be worked out. 

They can also be paid out before probate is granted, and can therefore get money quickly into the hands of your beneficiaries.

Can I reduce inheritance tax with a 'deed of variation'?

A deed of variation allows your heirs to alter your will after death so that, for example, part of the inheritance is re-directed to someone else.

They can draw up a deed of variation within two years of your death, but all affected beneficiaries under the will must agree to the variation. 

This can be difficult practically, especially if there are many beneficiaries, and there could be hefty legal bills to pay on the advice. 

As a general rule, it's better to review your will periodically so that your affairs are tax efficient. 

This will simplify the probate process for your executor, and reduce the chances of your loved ones squabbling, which sadly, can happen a lot.