Five common inheritance tax myths exploded

http://www.theguardian.com/money/2015/sep/08/five-common-inheritance-tax-myths-exploded

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To some, inheritance tax (IHT) is the most hated tax in Britain. To others, it is an engine of social fairness and wealth distribution. And to George Osborne it is a political weapon of astonishing power. The chancellor’s pledge in 2007 to raise the IHT threshold to £1m arguably changed recent political history by scaring the then prime minister Gordon Brown into postponing an election that Labour might have won.

In his emergency budget in July 2015 Osborne finally delivered on that pledge, and made the tax even more complex in the process. IHT isn’t just politically controversial, it is also widely misunderstood and the subject of a number of myths. Here are five of the biggest.

Myth 1: inheritance tax raises lots of money for the government

IHT is a tax that is fairly easy to avoid and which raised just £3.7bn in the 2014-15 tax year, just over 0.7% of the £513.5bn total collected by HM Revenue & Customs. VAT, by comparison, raised £111bn – about 30 times as much.

Karen Rowlingson, professor of social policy at the University of Birmingham, argues that the state should actually aim to raise more from IHT. “At the moment we tax earned income far more than unearned wealth, and that doesn’t seem fair,” she says.

IHT could also help reduce wealth inequality, which sees the richest 10% of UK households own 850 times more wealth than the bottom 10%. Fewer than one in 20 pay IHT, Rowlingson says: “We could double this proportion and still only tax the wealthiest 10%, leaving the vast majority to bequeath all their wealth without paying any tax at all.”

Myth 2: IHT only hits the super-rich

IHT may not be immoral, but it is unfair. The super-rich rarely pay, protecting their wealth through measures such as setting up trusts or buying assets that qualify for business property relief. Increasingly, the burden has fallen on the middle classes – especially those living in property hotspots in London and the south-east of England, which now account for half of the IHT tax take, according to figures from Prudential. Their average bill is £166,000.

That is due to a combination of rising house prices and an IHT nil-rate band that has been frozen at £325,000 since the 2009-10 tax year; the government plans to keep it at that level until 2021.

If the nil-rate band had increased with inflation, as measured by the consumer price index (CPI), it would now be worth approximately £378,000, according to accountancy firm Deloitte.

In 2009, the average London property cost £302,411, just below the IHT threshold. Today, it is almost £150,000 above at £474,544, Land Registry data shows.

Myth 3: I can pass on £1m free of tax

Osborne’s grandstanding move to raise the IHT allowance to £1m isn’t quite as generous as it seems. The new limit will take several years to come into force and even then many families won’t feel the benefit. The chancellor announced a new transferable allowance worth £175,000 for parents who leave their main home to their children and grandchildren. That effectively lifts the IHT nil-rate band from £325,000 to £500,000 per parent, or £1m for married couples and civil partners. However, as Standard Life spokesperson Julie Hutchison points out, “it will not increase if you are supporting nephews, nieces, children of friends and so on”.

The additional nil-rate band will be worth £100,000 when it is introduced in the 2017-18 tax year. It will then jump by £25,000 over each of the subsequent three years until it finally hits £175,000 in 2020-21. From that point it will rise in line with inflation. The additional allowance will only apply to family homes – it won’t cover other assets, including buy-to-let properties and second homes – and will gradually be withdrawn for estates worth more than £2m.

Myth 4: My partner will inherit everything free of IHT

Many people assume that if they are married or in a civil partnership, IHT isn’t an immediate concern. But they may be wrong, as the family of comedian Rik Mayall recently discovered to its cost. Although the star of the Young Ones and Bottom was married, he had failed to write a valid will, says Emma Myers, head of wills, probate and lifetime planning for Saga Legal Services. “This means his estate was subject to the rules of intestacy, so that a portion will automatically go to his children, thus triggering an IHT charge that would have been avoided had his entire estate been left to his wife.”

The rules of intestacy changed in October 2014 and are now much more in favour of the surviving spouse, Myers says. But even now, where there are children there is no guarantee that the spouse will inherit everything, she adds. “The key point is that it is absolutely vital to make a will. It is the only way you can exercise control over who gets what, and how much.” This is particularly important for unmarried couples, especially those with children. Myers says: “Although writing a will won’t spare them an IHT charge if their estate is over the threshold, certain types of will can minimise that charge.”

If you are not married you do not get any kind of special exemption on money left to your partner, so if your estate is worth more than £325,000, there will be a bill.

You can make gifts of up to £3,000 a year to whoever you like and the money will be exempt from IHT when you die

Myth 5: You can avoid IHT by giving all your money away

You can’t simply give away all your wealth shortly before you die and escape IHT. HMRC is wise to such tricks. You have to survive at least seven years after making a gift. Until then it is known as a “potentially exempt transfer” and may fall back into your estate and be liable for IHT if your estate’s value exceeds the nil-rate band when you die (although taper relief reduces the bill).

But there are other ways of giving away money. You can steadily whittle away your family’s IHT liability by making gifts to your loved ones. Tim Walford-Fitzgerald, tax expert at chartered accountant HW Fisher & Company, says: “You can make gifts of up to £3,000 a year to whoever you like and the money will be exempt from IHT when you die.” This is known as the annual exemption and you can mop up any unused £3,000 exemption from the previous tax year. Couples can give away double these sums.

On top of this exemption, you can make small gifts up to the value of £250 to as many individuals as you like in any tax year. But you can’t give someone another £250 if you have given them a gift under the £3,000 exemption. Walford-Fitzgerald says you can give wedding gifts free of IHT too: “The couple’s parents can gift up to £5,000 in cash each and grandparents can gift up to £2,500 each. Others can give up to £1,000.” And if you give at least 10% of your estate to charity, the 40% IHT tax rate falls to 36%.

Sean McCann, a chartered financial planner at NFU Mutual, says one little-known option is to make gifts out of normal expenditure. “You can give away an unlimited amount of ‘surplus’ income provided the gifts are regular and you are left with enough income to maintain your normal standard of living.” The exemption won’t apply if you make gifts out of income while living off your capital instead.