Thousands of people could be needlessly paying large inheritance tax (IHT) bills each year as a once widely-used tax loophole has been all but forgotten.
Everyone has a personal IHT allowance – the nil-rate band – of £325,000, above which their estate pays 40pc tax. There is also an additional allowance for passing a family home to direct descendants worth £175,000. Married couples and civil partners can combine their allowances, allowing many to pass on up to £1m tax-free.
However, there are ways individuals can get almost the same amount of protection too.
Before spouses were able to combine their tax breaks, many used IHT-exempt discretionary trusts instead. Often referred to as “nil-rate band trusts”, they allowed people to ring fence up to £325,000 to pass on to their spouse free of tax on their death.
The transfer of allowances has meant this practice has more or less died out. However, widowed spouses who remarry can still use it to give themselves an additional IHT allowance of £325,000, shielding even more from the taxman.
Faye Silver of Raymond James, the wealth manager, said this would benefit people who had lost their partner but who could still remarry.
How the inheritance tax trick works
Margaret is married to Peter. Peter dies and some years later she marries John. There are no children involved, so the family home allowance does not apply.
Peter’s death leaves Margaret with his full basic allowance, giving her £650,000 of IHT protection. She puts the £650,000 into a discretionary trust for John. On her death, John can add this to his own £325,000 allowance.
John also ringfences his own allowance through a trust, so Margaret can add his £325,000 to her allowance if he were to die first. Now the surviving spouse will pass on £975,000 tax-free.
What is more, beneficiaries can use this tactic retrospectively. By using a legal document known as a deed of variation up to two years after death, families can alter a will to be more tax efficient.
Rachael Griffin of Quilter, another wealth manager, said such “little-known quirks in the tax system” were increasingly important as booming house prices push the death tax take to record highs.
“Navigating the tax system shouldn’t be akin to finding a needle in a haystack. People are entitled to use allowances, even if few people have heard of them,” she said.
For more advice, read how to reduce your inheritance tax bill