How inheritance tax could be about to change

The chancellor is said to be planning sweeping changes to inheritance tax in her inaugural budget on Wednesday, in a raid that could raise billions for the government.
Families are handing over a growing share of their estates to the taxman every year thanks to frozen allowances and years of house price growth and high inflation. One in eight people are expected to have a taxable estate by 2032, according the Institute for Fiscal Studies (IFS), a think tank.
Rachel Reeves is understood to be targeting valuable inheritance tax (IHT) reliefs that allow families to pass on large chunks of wealth tax-free. This is how an IHT raid could affect you.
Everyone gets a £325,000 IHT-free allowance to pass on when they die. Those leaving a family home to a direct descendant with an estate worth less than £2 million get an extra £175,000, called the residence nil-rate band. Assets left to a spouse or civil partner are exempt from tax, and you can also inherit a partner’s allowance, so couples can together pass on up to £1 million tax-free.
If an estate is worth more than £2 million, £1 of the residence nil-rate band is lost for every £2 over that limit. That means that on an estate worth more than £2,350,000 the residence nil-rate band will be zero.
Anything above these thresholds is generally subject to IHT at 40 per cent when someone dies, but there are a number of allowances that can be used while still alive that allow families to shield more of their estate from the taxman.
You can give away up to £3,000 each tax year without the risk of it later being included as part of your estate. The annual allowance can be given to one person or split between several, and unused allowance can be carried forward by one tax year. A £250 per person small gift allowance is also available.
You can give £5,000 tax-free to a child or stepchild for their wedding or civil partnership — so a couple could pass on £10,000 in total to the same child. A tax-free gift of £2,500 can be given to a grandchild or great-grandchild, and £1,000 to any other person.
A report by the IFS last year found 5 per cent of adults had received one or more gifts worth £500 or more in the past two years. Most gifts were made by parents to children — typically in their twenties or thirties — worth an average of £2,000.
Abolishing these reliefs altogether could be seen as the government penalising ordinary families wanting to pass on smaller amounts of wealth to the next generation. But the chancellor could reform the system to combine the allowances and make them less generous.
In 2019 the now-scrapped Office of Tax Simplification (OTS) suggested replacing the marriage gift and £3,000 annual allowances with a single personal gift allowance, which would allow a person to give up to a fixed amount each year and without the option to rollover unused amounts.
Ollie Saiman from Six Degrees, a wealth manager for high-net-worth clients, said: “Many families regularly use these allowances, particularly those in their fifties and sixties.
“We have advised clients who are intending to make gifts over the next 12 months or so to consider making the gifts before the budget. I wouldn’t be surprised to see mid-year tax changes, even for some to come into effect from October 30.”
You can make regular gifts from your excess income that are exempt from IHT and it will not count towards any annual tax-free allowances, as long as the gifts do not affect your standard of living. This relief saves families millions of pounds in IHT each year and could be on the chopping block in the budget.
Gifts must be made from your normal income rather than sale proceeds from a house, for example, and cannot be given to the recipient for a one-off purpose. HM Revenue & Customs is keen on investigating this relief, so detailed records are needed to ensure your gifts qualify.
Tim Snaith from the law firm Winckworth Sherwood said: “You have to establish a pattern for giving, but it is possible to do this in as little as a year if your executors can prove after your death that the money was not intended for a one-off purpose, for example to buy a house.”
While it is uncertain whether Reeves will touch this exemption, the IFS has recommended abolishing it on the grounds that gifts out of income should be treated no differently from any other gifts.
“Regular gifts out of excess income would be an easy target for Labour to attack because it benefits high earners,” Snaith said.
In the 2015-16 tax year almost half of claims for this relief were for gifts worth more than £25,000 across a year, according to HMRC. If a gift this size was instead included in an estate and taxed at the full 40 per cent rate, it could trigger a £10,000 IHT bill.
The benefit of the £3,000 annual allowance and gifts from excess income is they are immediately excluded from your estate and will be IHT-free without being subject to the seven-year rule.
This rule is one of the most popular ways of passing on large amounts of wealth. Survive for seven years after making the gift and they are free of IHT — but die between three and seven years after and IHT is charged (on anything over the IHT allowances) on a sliding scale, reducing by 8 percentage points a year.
If the donor dies within three years of making the gift IHT is charged at the usual rate of 40 per cent.
• Inheritance tax: how extending the 7-year rule to 10 might work
There were almost 13,400 failed gifts — when someone dies less than seven years after giving the money — in 2020-21 and HMRC claws back hundreds of millions of pounds every year. “If a failed gift is taxable then the person who received it could be responsible for paying the IHT, so it’s important to have funds spare or insurance in place for any surprise tax bills,” Snaith said.
Reeves is said to be considering extending the number of years from seven to ten in a bid to make it harder for families to pass on wealth free of tax.
Snaith said: “The chancellor could also limit or remove the tapering relief on the seven-year rule. This would increase IHT raised for the government, but would create a huge cliff-edge system where if you fail to survive the full seven years by a few days your beneficiaries could potentially face IHT at the full 40 per cent.”
Under the present system if someone made one gift in their lifetime of £625,000 but died five and a half years later, it would still be counted in their estate for IHT. Their £325,000 tax-free allowance would be deducted from the gift, leaving a taxable amount of £300,000. Because they had survived for more than five years the rate of IHT would have tapered from 40 to 16 per cent, resulting in a tax bill of £48,000. If the tapered relief was removed and the gift was taxed at 40 per cent, the bill would more than double to £120,000.
• What are the inheritance tax rules and how could they change?
Snaith said lots of clients in their seventies made use of the seven-year rule once they had a better understanding of how much excess wealth they could spare in retirement. “People like seeing their family use and benefit from the gift while they are still alive,” he said.
If parents and grandparents start giving away funds earlier to mitigate an extended ten-year gifting rule, they risk running out of money in retirement, when they are vulnerable and care costs are likely to be highest.
Mark Stubberfield from the law firm Taylor Rose said extending the seven-year rule would also make it harder for executors of estates to prove to HMRC when a gift was made to qualify for the relief. “Most financial institutions will be able to provide statements going back seven years, but not longer. It may be impossible to find information for the missing three-year period and will significantly hold up the process.”
Pensions do not usually form part of your estate for IHT purposes, although if you die after the age of 75 your beneficiaries will pay income tax on money taken out of the pension at their usual rate.
Reeves is facing calls to apply IHT to retirement pots, with the IFS arguing pensions are being used by the wealthy as an “IHT avoidance vehicle” because they can use alternative assets to fund their retirement and leave their pensions untouched.
It said charging IHT on defined contribution pensions could raise £200 million this year, but this would rise to £400 million by 2029.
Abolishing the exemption could mean an IHT bill of £34,000 based on the average pension pot of £85,000 for savers aged over 55, assuming it was part of an estate that exceeded the IHT allowances.
When nominating the beneficiaries of your pension it is possible to ask that different people inherit the pot depending on when you die. You can nominate younger beneficiaries — such as grandchildren — to inherit it in the event you die after the age of 75. If they pay a lower rate of income tax then they will get to keep more of it than if you nominated a higher or additional-rate taxpayer.
• October budget 2024 predictions: what could Rachel Reeves announce?
Tax-free transfers between spouses and civil partners is the biggest IHT relief used by families, who transferred almost £16 billion of assets under this exemption in 2020-21.
When someone dies the value of their assets is reset for capital gains tax (CGT) purposes at the market rate — this is called the CGT uplift rule. The asset can be left to a surviving spouse free of IHT and this also wipes out the historical capital gains, potentially saving vast amounts in CGT if the asset is sold. For example CGT on second homes is paid at up to 24 per cent — if a property had risen £100,000 in value you could pay up to £24,000 in CGT when it was sold, but much of this could be avoided if the value had been reset for CGT purposes recently. Main homes are exempt from CGT.
“There is talk that Labour may remove the CGT uplift rule where IHT is not chargeable on inherited assets, for example between married couples, which could mean a tax bill for a surviving spouse,” Snaith said.
Limiting this relief could be costly for couples who have owned an asset for a long time. Basic-rate taxpayers pay 10 per cent CGT on most assets and 18 per cent on gains made from residential property. Higher and additional-rate taxpayers pay 20 per cent on most assets and 24 per cent on property.
Reeves is said to be considering raising the rates in line with income tax, which would mean higher and additional-rate taxpayers paying up to 40 per cent and 45 per cent on profits.