A decade of rising house prices plus smarter investing means more of us are going to be hit with a big inheritance tax bill. Sam Barrett explains the latest rule change and finds out how you can soften the blow.

Inheritance tax (IHT) was once a tax for the very wealthy. However, a decade of rising house prices and smart investments mean that an increasing number of us are likely to leave our loved ones with a substantial IHT bill.

IHT, which is set at a flat rate of 40%, is payable on the value of your estate above the nil rate band (£312,000 in 2008/09). Therefore, if someone dies with an estate worth £500,000, their beneficiaries will face an IHT bill of £75,200 - 40% of £500,000 minus £312,000.

And as your estate is made up of all your assets, including your home, investments and your share of any jointly owned items, it’s not surprising more of us are facing IHT liabilities.

Indeed, with house prices having risen by 219% since 1995, according to Halifax, and with three million homes now worth more than £300,000, IHT is catching more people out, solely on the value of their home.

Last year’s pre-Budget report did bring a little good news for some of those affected. “The introduction of a transferable IHT allowance will take a lot of people out of the IHT net,” says Bob Perkins, technical manager at Origen Financial Services. “In particular, many couples who would have had problems leaving their home to their families will not need to worry any more.”

The new rules

The transferable IHT allowance, which applies to married couples and civil partners, enables any unused nil rate band from the first death to be carried forward and used when the surviving spouse dies.

Previously, couples would either pass their assets to their partner IHT free, thereby wasting one of their nil rate bands, or they would set up nil rate band planning in their wills, leaving assets up to the value of the nil rate band to beneficaries other than the surviving spouse. If you have put in place an arrangement such as this, it’s worth reviewing it with your solicitor.

Under the new rules, if Mr Jones, say, died last November and all of his estate passed directly to his widow, when she dies, her beneficiaries will be able to use 200% of the nil rate band at the time of her death to reduce the value of her estate for IHT purposes - £624,000 based on today’s allowance.

If Mr Jones had given away £50,000 to other people in his will, then this would reduce the amount that could have been used on second death. In this example, the nil rate band was £300,000 when Mr Jones died, leaving his wife with an 83.3% uplift on her nil rate band - again, based on today’s allowances - that would give her an additional £260,000 on top of her existing £312,000 allowance.

As well as being able to index the first nil rate band to current levels, there is no cut-off point for the first death.

“I had one woman whose husband died in the Second World War, but she’ll be able to take advantage of a double nil rate band when she dies,” says Perkins. It doesn’t matter if you’ve subsequently remarried, although if you have had two spouses die, the maximum uplift you can take advantage of is 100% of your own allowance.

Your beneficiaries will also need to produce all sorts of documentation, such as the deceased’s will and death certificate, to support a claim for an uplift.

“If you are entitled to a deceased spouse’s allowance then you might want to capture all this information or make a formal declaration that the additional allowance exists before you die,” says Michael Greenwood, technical liaison manager and chartered financial planner at Towry Law. “This will make it easier to claim, and with potential IHT savings of as much as £124,800 (based on 2008/09 rates) to be made it’s certainly worth arranging in advance.”

However, even with the change, some people - for example, married couples with estates worth more than £624,00 or single people with more than £312,000 - will still face an IHT liability. If this is the case, there are plenty of other IHT planning options worth exploring.

Giving it away

Giving money away is a valid IHT planning route, and many people do like to see their beneficiaries enjoying their inheritance. However, there are rules to observe. It will be seven years before anything you give away - which is a potentially exempt transfer (PET) - is considered to be outside your estate for IHT purposes.

There are exceptions to this, thanks to a number of allowances. One that is often forgotten about is the gift out of surplus income. Stephen Herring, senior tax partner at BDO Stoy Hayward, explains: “Providing you can show that there is clear headroom between the income you receive and your expenditure you can give the excess away and it will be immediately outside your estate. This option is often overlooked, but it’s a useful relief.”

As well as these allowances, a deed of variation might be appropriate. If you have inherited anything in the last two years, you can apply to have it redirected.

For example, if you received an inheritance from a parent, but have sufficient money and a niggling IHT problem already, you could use a deed of variation to pass the inheritance to your children or grandchildren. “This won’t necessarily reduce the deceased IHT bill, but it will prevent money accumulating and avoid creating a future IHT liability,” explains Greenwood.

Trusts can also help in your IHT planning, allowing you to reduce liability while also retaining some control over the money. This could be useful if you want to pass money to your children but are worried about how they might spend it.

However, doing this has become much more difficult in recent years. “The government looks at trusts as if they are tax scams, but this isn’t always the case,” says Herring.

To demonstrate the government’s dislike for trusts, in March 2006 it clamped down on some of the more tax advantageous trusts by making discretionary trust tax treatment apply to all the main forms of trust. This means if your trust is worth more than the nil rate bond, a 20% initial charge will be applied to any excess, plus a 10-yearly charge of up to 6% and exit charges.

For this reason most people keep the trust below the nil rate bond.

A solicitor can arrange trusts for you, or you could also consider one of the trust vehicles put together by the life companies. These have the advantage of having HM Revenue & Customs approval.

The discounted gift trust is particularly popular among people who want to reduce their IHT liability without giving up a right to an income from the money. With these, a percentage of your investment is paid back to you as income.

“The amount you’d be entitled to will depend on your life expectancy,” explains Nick O’Shea, director of Canterbury-based IFA Pharon, who says between 45% and 50% is a fairly typical amount.

Reduce liability by investing

As well as giving away your wealth to reduce your IHT liability, you can make some investments that will also do this for you.

Shares in unquoted companies, those listed on the Alternative Investment Market (AIM), for example, qualify for business property relief, effectively taking them outside your estate for IHT purposes after you’ve held them for two years. Individual shares are suitable, or you could invest in a fund of unquoted company shares to spread your risk.

An Enterprise Investment Scheme will also enjoy the same IHT benefits, as well as additional income and capital gains tax advantages. You do have to be careful though, as not all AIM shares qualify. The company must be a trading one, so a financial company, for example, won’t be suitable.

Nick O’Shea adds: “These companies are often small and illiquid, so they represent a risky investment. You could easily lose 40%, which negates the IHT benefits.”

If unquoted shares aren’t right, relief is also available on investments into farmland and forestry. Again, you’ll need to hold them for two years for them to be exempt from IHT, and liquidity issues might be a problem.

Your pension may also provide some useful planning opportunities as O’Shea, explains: “If you don’t vest your pension by taking the tax-free cash, it will remain outside your estate for IHT purposes until you reach age 75 and have to take an annuity or alternatively secured pension.”

The remaining part of your investment will go into trust for whoever you choose. As this is a PET, it will take seven years to leave your estate, although any growth is immediately outside your estate.

Insurance is another option. Taking out a whole-of-life plan for the future liability will ensure the money is available to pay the tax bill, and providing it is written in trust, the payment will be outside your estate and available quickly to settle the bill.

Premiums will depend on your age, health and the amount of cover you require. It’s also worth checking the type of policy you’re taking out. Some come with reviewable premiums, which can become very expensive. A guaranteed plan will be more expensive initially but will give you the security that premiums will remain level throughout the policy, no matter how long you live.

Herring prefers using other methods for IHT planning but says insurance can have its place. He explains: “It’s not so much insuring against funding a future IHT bill. However, if you have a situation where a child lives in a parent’s home, insurance can ensure money is available to pay the IHT bill without forcing the child to sell the property to pay it.”

A final option - and possibly the most enjoyable of them all - is to spend it before the taxman gets a chance to stake his claim.

There is an art to this though, as you need to spend it on items that are either intrinsically worthless or - as is the case with holidays, food and wine - worth absolutely nothing once they’ve been enjoyed.

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