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 over the 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 £325,000 (in the tax year 2009/10 and 2010/2011). 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 or manage your potential inheritance tax bill:

• Making a will
• Making gifts
• Your family home
• Taking out life 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 qualifying 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 help reduce your inheritance tax bill could be to give your money away. This isn’t as reckless as it sounds. By making 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.

To be exempt, these gifts must also come from income, and not from 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 registered charities.

Gifts to other individuals that are not 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 value of the gift is still included in your taxable estate and the person who received the gift may have to pay some inheritance tax.
• Any 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 benefit from 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.
• 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. It's important to remember that if you make a gift of your home and continue to live in it without paying a commercial rent, its value would still be included in your estate for inheritance tax. 

Nil rate band planning with your home in this way is of less importance now that nil rate bands can be transferred between spouses and civil partners. This is a complex area of tax law and must be discussed with a suitably qualified professional adviser.

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 (written under an appropriate trust so as to avoid increasing the inheritance tax bill) 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 them for the benefit of people who will eventually be given them.
• 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. If an insurance policy is left in trust it may then be available to pay an outstanding IHT liability before the rest of the estate is released.

Trust law (and the related tax law) is complex. Anyone thinking of setting up a trust must rely on the advice of their own legal and/or financial advisers. Getting professional advice relevant to your own circumstances is important for a number of reasons:

• Creating a trust has taxation as well as legal consequences.
• Once the trust has been created it cannot be cancelled. 
• The trustees have a special duty to the beneficiaries and the misuse of a trust power by a trustee can make him or her personally liable for any resulting loss to the beneficiary.