Keep your wealth safe from inheritance tax

After years of inheritance tax (IHT) revenues falling, changes to the law in 2007 have meant the they are steadily starting to rise again - from £2.7 billion in 2010/11 to £3.2 billion in 2012/13, according to HM Revenue & Customs (HMRC).

Furthermore, due to rising house prices in London and the south east, the number of estates potentially liable for IHT is increasing: 20,000 individuals (or, more accurately, their estates) paid an IHT bill in 2011/12, up from 17,000 the previous year. HMRC estimates that 5,000 additional estates will be pulled into the IHT net by 2018, as a consequence of this latest extension to the threshold freeze.

You can find out how important estate planning is in ensuring your trustees aren't left with a giant tax bill in: Careful planning can help you beat IHT.

As well as the need for estate planning becoming more important, there are plenty of ways in which you can avoid paying IHT on your wealth.

IHT-exempt gifts

Most gifts of money are what are known as potentially exempt transfers (PETs) and therefore have a potential IHT liability. But certain categories of gift, up to certain levels, have no tax liability, and are therefore a good way to start if you want to reduce your estate's value.

Gifts out of income

IHT-exempt gifts out of your regular income don't have to go to a specific individual.

They can also be made into a discretionary trust (where they will not count towards the nil-rate band for IHT).

A tax-efficient alternative, says Nash, is to gift say £250 a month (ie £3,000 a year) to your grownup child; they can then use it to pay up to £2,880 a year into a stakeholder pension plan on which they will get full pension tax relief.

"Not only is there no inheritance tax to pay on that cash from the parent, but the child gets full pension tax relief. In effect, a £3,600 pension contribution is costing only £1,728, even if the child is only a basic-rate taxpayer," Nash explains.

• Annual gifting allowance: you're allowed to give up to £3,000 in a tax year to a single person (or split it between several people) without any liability, so a married couple can gift up to £6,000 per year in this way. It's also possible to carry forward the previous year's £3,000 allowance if you didn't use it then.
• Small gift allowance: You can also make any number of gifts of up to £250 to any number of people (though not the recipient of the £3,000 annual gift).
• Marriage: Gifts can also be made free of IHT to couples getting married or becoming civil partners - each parent can give the couple up to £5,000, each grandparent can give £2,500 and anyone else £1,000, while the partners themselves can give each other up to £2,500.
• Gifts out of normal income: Under this valuable but often overlooked tax-planning tool, if you don't spend all your earned pension or investment income, you can make regular payments of surplus cash to your children or grandchildren. There is no cap on the amount that can be given away this way.

However, cautions Frank Nash, tax partner at accountant Blick Rothenberg: "It's important to be able to demonstrate that the payments are not impacting on your living standards, and that they are clearly out of income - they need to come out of your current account, not out of savings."

Write to the recipient making clear that this regular gift is out of spare income; in fact, it's sensible to send an explanatory letter and keep a copy whenever you make a gift of any sort with an eye to IHT.

Potentially exempt transfers

Beyond the use of your annual exempt gift allowances, if you have enough capital and income to meet all your current and foreseeable needs, the simplest way to reduce your estate is simply to make outright gifts, says Neil MacGillivray, head of technical support at James Hay Partnerships.

These are treated as PETs, meaning they will fall out of your estate if you live another seven years; if you die in the meantime there may be IHT to pay even though they belong to someone else.

For people who do not want simply to give their wealth away in this way, a range of trusts may solve the problem. Although most gifts to trusts are these days subject to IHT (20% when assets enter the trust plus 6% every 10 years) on assets above the value of the NRB, they provide a way of retaining control over the assets you gift.

Discretionary trusts

This is the most widely used trust. Instead of giving assets directly to the recipients, you place them in a trust where the trustees (typically including you as donor) have full control over who gets access to what, and when. Provided no more than £325,000 is placed in the trust (or £650,000 for couples), there is no tax charge on entry.

These gifts fall out of your estate if you live another seven years, at which point you can put a further NRB's worth into trust. Once the assets are in the trust, any income generated or growth in their value is outside your estate.

Discretionary trusts are extremely flexible. "Trustees can respond to the individual circumstances of particular beneficiaries, and can also use the annual personal tax allowances of their adult children or grandchildren," says Nash. "In addition they are very tax-efficient, particularly as capital gains tax (CGT) on gifts put into the trust is deferred until they are sold."

In addition, says Ronnie Ludwig, tax partner at accountant Saffery Champness, it's possible to specify classes of people or specific individuals you don't want to benefit from the trust. "You can, for instance, stipulate that you don't want your children's spouses to receive money, which means you can ensure the family doesn't lose money if one of them divorces."

Ludwig also stresses that it makes sense to put assets into trust when market values are relatively low. "At present it's a good time to gift, say, a holiday home or buy-to-let property, because you can get so much more for your NRB," he explains.

Will trusts

If you don't want to leave assets directly to your beneficiaries, this is a discretionary trust triggered by your death: you simply write a will specifying that you leave £325,000 worth of assets in trust for your spouse, children or grandchildren on your death. "It doesn't save IHT, but it is a useful planning strategy," adds Ludwig.

Loan trusts

This option works well for people who don't want to give away capital but don't want further growth (for example, because their estate value is around £325,000). It involves lending cash to the trust (which is typically then invested in a life bond), rather than giving it outright; once within the trust, any investment growth belongs to the beneficiaries, but the donor can access the capital if needed, and can also draw an "income" in the form of loan repayments.

MacGillivray gives the example of a £100,000 loan to a trust, which is used to buy a bond. "Say the lender dies 10 years later, having taken loan repayments of £50,000, and the bond is worth £70,000. The remaining £50,000 of loan belongs to his estate and the £20,000 of growth goes to the beneficiaries, free of IHT."

Discounted gift schemes

These are widely used by financial planners for people who want to reduce the value of their estate but still need an income from it. They consist of an insurance bond written in trust, that pays out a set "income" (in reality a chunk of the capital investment) each year. If you survive seven years, the value of the bond falls out of your estate altogether, while you continue to receive an income.

However, when the bond is set up, the value of the gift is immediately discounted by a certain amount (depending on factors such as age and health), to take account of the value of the "income" being paid out over your expected lifetime. So if you die within seven years, the bond is still within your estate but its value is significantly reduced.

For instance, says MacGillivray, "for a woman aged 70 in good health and taking an income of £5,000 a year, the discounted value of a £100,000 gift would be £47,247. So the value of the gift would more than halve". Discounts of up to 70% are possible for older people in good health.

IHT-exempt investments

Wealthy individuals looking for estate planning opportunities may consider a range of alternative investments that qualify for special reliefs, which in most cases means they are exempt from IHT after only two years of ownership rather than seven. These include business property, agricultural land, woodland, unquoted and Alternative Investment Market (AIM) shares and enterprise investment schemes (EISs).

Business property relief (BPR) applies specifically to trading companies, so a portfolio of buy-to-let properties will not qualify. But there are various grey areas, including businesses such as caravan sites and holiday lets, where qualification for tax relief is dependent on the level of additional services provided. In effect, HMRC expects them to be run as active trading companies to qualify, rather than property investment companies.

What about agricultural land? If you're farming the land yourself, you need only hold it for two years before it qualifies for agricultural property relief; but investors typically buy and rent land out to a farmer, in which case they must own it for seven years to get IHT relief on the land value. Importantly, it needs to be actively farmed.

Unquoted and AIM shares also qualify for BPR, but can be volatile and are definitely not for the fainthearted. But Frank Nash makes the point that in fact many AIM companies are pretty well established businesses; he cites Majestic Wines and Young & Co's Brewery as robust examples.

"Another option for parents wanting to pass money to a child with their own unquoted business is to buy shares in it; the shares would be exempt from IHT after two years, and the parents could then gift them to the child," he suggests.

BPR also underpins a range of low-risk schemes run by the likes of Octopus, Ingenious and Downing, designed to provide IHT relief. The schemes invest clients' money into their own BPR qualifying businesses, such as films or renewable energy.

EISs and their junior siblings, seed EISs (SEISs), are designed to boost private investment into early-stage UK companies. They are high risk because there is no established secondary market where investors can sell if they need to - but to compensate for that illiquidity EISs offer a raft of generous tax breaks, including 30% income tax relief, CGT deferral and full inheritance tax relief on funds held on your death. However, they are useful mainly as tax breaks and for deferring CGT.

Preparation for a liability by making provision for tax

A simple option, which can also be relatively cheap if you're young, is not to aim to reduce your IHT bill but simply to make provision in advance for the likely tax your estate will have to pay when you die.

One option is to set up a whole-of-life insurance policy (written in trust so that the payout doesn't become part of the estate) that will pay out a sum calculated to meet the IHT bill on your death (or a joint policy that pays out on the second death, if you're a couple).

Your monthly premiums will be determined by your age. Beyond this, you have a choice of a guaranteed fixed premium for the rest of your life, or the cheaper alternative where the premium is reviewed after 10 years, becoming much more expensive over the years as your life expectancy falls.

Lamb gives the example of a couple aged 65 who want a payout of £300,000 on the second death: Guaranteed premium - £417.50/month 10-year review - £55/month, but rising to £379/month at age 75 (assuming no change in rate ranges over that time).

Lamb says it would probably increase by a further 700% (to around £2,600/ month) at age 85.

Your choice likely depends on issues such as your life expectancy and how much you can afford at this time: the longer you live, the better off you're likely to be with the more expensive version.