It is more and more likely that you will need to consider inheritance tax in your financial plans. Although it used to affect only the very wealthy, the sharp rise in house prices in the past few years means that more people have fallen into the inheritance tax bracket.

The good news is that the threshold does usually increase each year, and there are ways that you can reduce the potential inheritance tax bill, or even eliminate it altogether.

What is the rate of inheritance tax?
Inheritance tax is payable if the value of your estate exceeds £312,000 (in the tax year 2008/09). Tax on any part of your estate which is above this threshold is charged at 40%.

What is included in an estate?
Your estate includes everything you own, less any outstanding bills you have to pay, at the time of your death. Even if you give away some of your assets during your lifetime, such as property or money, they may still be included in the value of your estate, if gifted within 7 years of your death. 

If you leave your estate to your husband, wife or civil partner, they will not generally have to pay any inheritance tax. But if you pass your estate to your children or a friend, they could get caught out, especially as the tax bill usually has to be paid before they can receive anything you have left them.

There are five main things you should think about to reduce your potential inheritance tax bill:

• Making a will
• Making gifts
• Your family home
• Taking out insurance cover
• Using trusts

The first step in inheritance tax planning is to make a will and keep it updated. Remember that the only way of ensuring that your estate goes to the people you want it to is to make a will.

Although you can make your own will, you should get professional advice as a badly written will is almost as bad as having no will at all.  And it’s important to talk through your plans with the people you want to benefit from your will – this may seem awkward, but it really is best to have everything out in the open to avoid any confusion or upset at a later date.

Remember, no inheritance tax is payable on anything a husband, wife or civil partner inherits if you are both UK domiciled, and anything you leave to a UK charity or political party would also be exempt. If your estate goes to anyone else, including your children, they could be liable for inheritance tax. Splitting your estate between two or more children will not help, because it is the value of your whole estate, not the value of what each individual inherits, which will determine the amount of tax payable.

One way to avoid inheritance tax is to give your money away. This isn’t as reckless as it sounds. By leaving gifts, you reduce the value of your estate and so reduce the potential tax bill.  Under the inheritance tax rules, gifts may be either exempt, potentially exempt or immediately chargeable. Please note, tax rules may change in the future.

Gifts from your regular income

The technical term for these gifts is ‘normal expenditure out of income’. These gifts are exempt, but there are some strict rules to follow. You must be able to show that, by giving the gifts, you are not affecting your own standard of living, or giving away money that you would otherwise need.

You can give regular gifts from your income, but not from your capital. For example, you can make a regular gift from the interest you earn in your savings account, but not from the capital you may have in a savings account.

Other gifts which are exempt

• You can give your children £5,000 or your grandchildren £2,500 when they get married.
• You can give anyone an annual gift of up to £3,000. This can go up to £6,000 if no gift was made in the previous year.
• You can give any number of small gifts (up to £250) to different individuals during a year. This cannot be combined with the gift in the previous bullet.
• You can make gifts of any amount to charities.

Gifts to other individuals that are exempt

The technical term for this is a ‘potentially exempt transfer’. You can give away any amount you like with no upper limit, but again, there are rules:

• You must live for at least seven years after the transfer, otherwise the person who recieved your gift will have to pay inheritance tax on it.
• The tax payable on the gift if you die within 7 years of making it is reduced if you survive for at least 3 years and the gift is more than the nil rate band.
• You cannot continue to use the gift. For example, if you gave your house to a relative you could not continue to live there without paying fair market rent to that relative.

Gifts into trust fund (other than a bare trust)

The technical term for this type of gift is 'chargeable lifetime transfers'. Depending on the amount of the gift and the total of any other chargeable lifetime transfers you have made in the last 7 years, part or all of the gift may be immediately chargeable to inheritance tax at 20%.

If you are considering making this type of gift you should always talk to your legal and/or financial adviser.

There are ways of using your family home to reduce the value of your estate.

• You could sell your home and downsize to something smaller and cheaper, you can then give away the remaining money using a ‘potentially exempt transfer’, or simply spend the money.
• You could release equity from your home and give it away as a gift, or simply spend the money.
• Married couples and civil partners can make efficient use of their IHT nil rate bands by leaving a share of their family home to someone other than the surviving partner on first death. This is a complex area of tax law and  must be discussed with a suitably qualified professional adviser.

It’s important to remember that you can’t make a gift of your home and continue to live in it without paying commercial rent. If you did this, its value would simply be added to your estate on your death when the inheritance tax liability is calculated.

If you’re concerned about leaving a big tax bill, you shouldn’t wait. A tidy and easy way to plan for inheritance tax is to take out an insurance policy.

You can take out a policy that will pay out an amount on your death roughly equal to your inheritance tax liability. This will then give your loved ones enough money to pay the inheritance bill, and so relieve them of the burden.

Obviously, this is not an exact science and tax law can be complex, so it is wise to speak to a financial adviser.

Trusts can be another good way to reduce potential inheritance tax.

You can

• pass ownership of your assets to trustees who will look after it for the people you will eventually leave it to.
• decide who receives the assets and when.
• set up the trust during your lifetime or leave instructions in your will that a trust be set up in the event of your death.

From 22nd March 2006, new rules about assets transferred to trusts will apply. Any transfer exceeding the inheritance tax threshold will be subject to an immediate 20% charge for inheritance tax.

However, some types of trusts are still exempt from this charge. They are:

• Trusts created on your death for your child in which they will become fully entitled to the assets at age 18. 
• Lifetime transfers into a trust for a disabled person. 
• Trusts created on death for a disabled person. 
• Trusts set up under a will for someone who is not a disabled person or minor child of the deceased who becomes entitled to their benefit on the death of the person who wrote the will.

Remember, if you put something into a trust in your lifetime, you give up your legal rights to it. It is, therefore, a good idea to get professional advice before doing so.