This piece first appeared in Reader's Digest in September 2001
The text here may not be identical to the published text
"In this world, nothing can be said to be certain, except death and taxes". Benjamin Franklin might have added today that inheritance tax neatly combines them both. You spend all your life working, saving, buying a home, building up your life and possessions – and paying for all of them out of taxed income. And then when you die, the Government steps in and taxes what you leave. You can understand the man who said "You are born with nothing. So if you die in debt you’re ahead."
Most of us though do not want to live like that and inheritance tax is quite rightly a growing fear. It starts biting when someone dies and leaves an estate worth more than £242,000. Everything above that is taxed at 40%. Many people, particularly in the South of England, have a house worth more than that. So although only a minority pay it, inheritance tax is extending its reach. It brought the Chancellor £2 billion in 1999/2000 and the amount is growing by nearly 8% a year. The reason is not hard to find. Over the last five years the starting point for the tax has risen by less than 4% a year. But house prices have risen by nearly 7% a year. Economists call this ‘fiscal creep’. And it brings more people within shouting distance of being taxed at 40% after they are dead.
It is not necessarily the rich who pay inheritance tax. They can afford lawyers and accountants to help their heirs avoid it. But most ordinary folk never think about inheritance tax. So this month I am going to explain what you can do to protect your heirs.
Give it away now
Unfortunately you can’t just give your money away. If you make a large gift and then die within seven years it will count as part of your estate. Though if you live more than that no tax will be due on it. And are amounts you can give away every year without them counting at all.
·You can give away £3000 in any tax year. And you can carry this allowance forward by one year so if you gave nothing away last year you can give away £6000 this year.
·You can also give up to £250 to any number of individuals – though no individual can benefit from this and the £3000.
·You can give extra amounts to people when they marry - £1000 to anyone; £2500 to a grandchild or great-grandchild; £5000 to your own child.
·You can make a gift of any amount if it is for the maintenance of a dependent relative.
·If you have a high income you can give away any amount each year as long as it is out of income rather than your capital
These limits are personal, so a husband and wife can each make them. However, they are not so generous as they seem. None has been increased since inheritance tax began in March 1986. To have kept pace with inflation they should be nearly doubled.
The major exemption from inheritance tax is between spouses. Anything inherited by your husband or wife is completely free from the tax. But that does not mean you should take no action until after the first partner has died. Consider this. You own goods and property worth £450,000 between you. When the first dies it is all left to the spouse so no inheritance tax is payable. When the second dies, the estate is well above the £242,000 limit and tax at 40% is due on the excess of £208,000. So your children end up giving the Chancellor £83,200. But if you split the property in half before you die, so that you each own £225,000, then when the first dies, they leave their property to the children and it is exempt as it is less than £242,000. And when the second dies and leaves the remainder to their kids, that is also below the limit for the tax to bite. Saving £83,200.
The problem is of course, that for most people the threat of inheritance tax hangs mainly over their home, and that is harder to split. The first thought most people have is to give their home to their children but then continue to live in it. Unfortunately that ruse does not work. If you give something away but continue to benefit from it, the property continues to count as part of your estate. The Revenue calls it a ‘gift with reservation’. But there is something you can do to protect your home from the taxman if you are married.
In England and Wales, most couples own their home as what is called ‘joint tenants’. That means that they each own all of it; neither has a separate share they can give away or sell and when one dies the other simple assumes ownership of the whole property. The other way to own a property is as ‘tenants in common’. If you own it that way, then each of you owns a stated percentage of the property – normally 50% each but it can be any ratio you agree. So the first step is to change your ownership to be tenants in common. You do that by simply writing to each other stating that the property will from now on be held as beneficial tenants in common by you and your spouse in equal shares. The law is similar in Scotland.
Then, you each make a will leaving your own half to your heirs. When the first dies, then the child inherits half the house. They can then allow you to stay using their half of the property until you die or the property is sold. When the second spouse dies then the child inherits the other half of the home. By splitting it in this way you can keep a home worth well over £242,000 out of the grasp of the taxman, depending of course on your other assets.
There are risks in this scheme. First, you have to be able to trust your heirs to allow you to live in the house. You cannot make that a condition of the will. Second, if they go bankrupt or divorce or die before you, then the ownership of their half of the home will pass to someone else who may be less helpful. Thirdly, if they get a means-tested benefit, such as income support or housing benefit, then owning your half of the property might stop them getting it. So take legal advice before embarking on this scheme.
If a person dies as a result, or partly as a result, of an injury received on or made worse by active service in the armed forces then their whole estate may be exempt from inheritance tax. And business assets are also largely exempt from inheritance tax. Finally, beware of schemes offered by financial advisers that involve setting up a trust. These work for the very rich. But if your assets are more ordinary, and consist mainly of your home, they are unlikely to work for you.