It’s a rare achievement for a tax to be incurred by just a fraction of people but to be widely detested.
Inheritance tax pulls that trick off. Despite it only currently affecting about one in 20 estates, it is referred to as Britain’s ’most hated tax’.
Sometimes a tax is so toxic that it desperately needs reform and should probably just be axed, even if some of the potshots at it fall wide of the mark.
Inheritance tax (IHT) is one of those. It manages to give the tax system a bad name and pollutes people’s views on its fairness.
Yet, somehow, instead of changing inheritance tax for the better – or just getting rid of it – successive Chancellors have managed to either sit on their hands on much-needed reforms, or tinker to make it even worse.
Now having already placed herself in the latter camp at the last Budget, with a raid on pensions, farmers and businesses, Rachel Reeves is rumoured to be mulling plans to hike inheritance tax to raid taxpayers again.
At the lower end this involves talk of hacking back allowances for early inheritance gifts, while at the extreme end it involves rumours of a lifetime gifting cap.
This would be a radical shake-up that severely limits the ability to hand down money and mean a hard cap on what you could give away in your lifetime, with everything else above that taxed at 40 per cent.
Rachel Reeves is rumoured to be planning another Budget inheritance tax raid
That ‘most hated’ label may date back to a survey that’s now in the distant past, but inheritance tax has only become more unpopular since, not least because its application is an unholy mess that’s dragging more and more people into its trap.
Inheritance tax is hugely unpopular because it is levied at a swingeing 40 per cent, more families are being caught out due to the thresholds being frozen, it’s riddled with complexity and the key gifting allowances date back to the mid-1980s.
This first point means that for those who get caught out by inheritance tax, bills can be huge and run into hundreds of thousands of pounds.
The second point means there are more of those people and Ms Reeves’s plan to pull pension pots into inheritance tax from 2027 has dramatically upped the ante.
Meanwhile, the third point means you can give away just £3,000 tax-free in a year – the same amount as in 1986 – and your estate could potentially be taxed if you are unfortunate enough to die after paying for a big family holiday or buying your 18-year-old a second-hand car.
The problems with inheritance tax are staring us in the face, yet beyond former Chancellor George Osborne’s cack-handed extra allowance for passing on your home – but only to a direct descendent – no one in power has taken it on themselves to improve the situation for two decades.
Instead, successive Chancellors – most of them Conservatives – allowed it to become a stealth tax increasingly directed at mass affluent middle-class homeowners in parts of the country where homes cost more, with those frozen thresholds snaring ever more families.
Thresholds failing to keep up with house prices and asset inflation have led to IHT moving from a tax on the genuinely rich to one that catches the mass affluent
What makes the situation even more galling is there is an official report gathering dust that outlined the problems with the inheritance tax system and gave some recommendations on what to do about it.
Back in January 2018, then Chancellor Philip Hammond asked the Office of Tax Simplification to carry out a review of inheritance tax.
Its comprehensive report was about as damning as you can get with this kind of dry document. It said inheritance tax was unfair, crucial allowances were outdated and called for an urgent overhaul.
Seven years later, none of those issues have been tackled.
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Instead, as mentioned above, the current Chancellor decided to make it a bigger problem for more people by bringing unspent pension pots into the inheritance tax mix from April 2027.
This came with the threat of 60 per cent-plus effective rates from double taxation for those who died after 75 and face both IHT and income tax on withdrawals by their beneficiaries.
Farmers and family business owners also saw a valuable exemption dramatically hacked back.
Perfect timing for farmers who had just suffered the toughest year and worst harvest in decades, and small businesses also being hit with an employers’ national insurance hike.
The Office of Tax Simplification report painted a picture of inheritance tax as a total shambles. Despite only being paid by a small percentage of estates, it manages to create an administrative nightmare for many more whose loved ones have died.
In November 2018, the OTS said: ‘Many also told us that their relative had worried about inheritance tax during their lifetime, even though it was not going to affect them.’
Currently, inheritance tax is charged at 40 per cent on estates above the individual nil rate band of £325,000, with an extra £175,000 allowed tax-free for those passing their own home on to direct descendants.
Married couples and civil partners can pass assets to their surviving partner IHT-free at death, creating an effective total allowance of £1million. For the childless, single parents and the unmarried, these allowances are the first bit of unfairness.
A cornerstone of inheritance tax is limiting how much people can give away before gifts get caught in the potential net of 40 per cent tax.
If you breach these gift limits, you must survive for another seven years for the gift to become inheritance tax-free. Die before then and tax is charged on a sliding scale.
The OTS highlighted how outdated these limits are, as they have not been raised since inheritance tax was introduced in its current form in 1986.
The frozen main gifting limit means you can give away just £3,000 per year before ending up with a potential inheritance tax liability.
An exemption applies for weddings, whereby a parent can give £5,000 or a grandparent £2,500.
Alternatively, you can make unlimited small gifts worth up to £250 but you can only make one per
This creates some potential scenarios for anyone unlucky enough to die within seven years, where the beneficiary could end up liable for inheritance tax if you:
Buy your 18-year-old a second hand £5,000 Ford Fiesta
Split your daughter or son’s wedding (the average cost is claimed to be £20,000)
Take the family on a big holiday
There is an IHT exemption for making regular gifts out of surplus income, but this is a grey area and you can’t use it to give your savings away, only regular gifts out of income.
There were 11 recommendations made by the Office of Tax Simplification. The key one for most people was around gifts, where a new simpler overall annual allowance at a higher level was recommended, along with reducing the seven-year rule to five.
If the rumours are true, Ms Reeves may be planning the opposite. Instead of recognising how outdated those gifting allowances are, that thresholds should rise with inflation, and cutting the seven-year rule to five would be a welcome move, she could use them to stage a raid.
There’s talk of gifting allowances being hacked back, the seven-year rule becoming ten, and a further freeze or even reduction of the tax-free inheritance tax threshold.
All of this would be counter-productive and wouldn’t even raise that much money. Inheritance tax accounts for about £8.2billlion of the UK’s total £858billion annual tax receipts.
Even doubling that would be a drop in the ocean when it comes to balancing the books, while coming at the expense of generating reams of unfavourable headlines and comments.
I know that many on the left hate the idea of inherited wealth – I appreciate but disagree with their arguments why – but even they must see inheritance tax is so toxic that we need to make it look fairer for the sake of the wider tax system.
Meanwhile, we should be encouraging not discouraging early gifting. Money being handed down the generations and spent, invested or put into buying homes, is good for economic growth.
We need that growth so that we can stop introducing ever more catches in the tax system, reform bad taxes like inheritance tax and keep Rachel Reeves and the Chancellors who will come after her from taking more of our money and creating a bigger mess.
How to protect yourself against inheritance tax
There are plenty of complicated IHT schemes but the easiest and cheapest ways to avoid inheritance tax are to spend your money while you are still alive or gift it early.
Some financial advisers have told me that they say to clients whose estates will definitely incur an inheritance tax bill to think of spending as getting 40 per cent off.
If you know the taxman will take a 40 per cent chunk of your wealth above the thresholds, then why not splash out on a nice holiday, new kitchen, premium economy or even business class flights.
Before you go on a spending spree though, make sure that you are leaving yourself enough money to last you the rest of your lifetime.
Beyond spending while you can, the obvious way to pass money to your family without incurring a bill is through gifting.
The standard annual inheritance tax-free gifting allowance is £3,000 in total for an individual. Beyond this, any amount can be gifted, but you must survive for seven years for it to be free of inheritance tax. Die before then and inheritance tax is charged on a sliding scale. The earlier you give money away the better.
If you are intending on making gifts, whether within the tax-free allowances or above them, it may be wise to consider doing this ahead of the Budget. Retrospective tax changes are unlikely but new rules can sometimes kick in immediately.
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A valuable IHT loophole also exists, known as gifting out of surplus income. This allows unlimited inheritance tax-free gifts, provided they are part of a ‘regular pattern of giving’ and made from income that isn’t required to maintain your usual standard of living.
Keeping good records is essential here, as your executors will need them down the line to prove the date and regularity of the gifts and that they came from income and your lifestyle wasn’t affected.
Gifting from surplus income has surged since the announcement than pension pots would be pulled into the IHT net. There is talk that Rachel Reeves could take out this loophole in the Budget, but some experts say she may leave it.
Our retirement columnist Sir Steve Webb said that with people making withdrawals from pensions to do it, the Chancellor gets from income tax now at the expense of inheritance tax at an unspecified date in the future. That benefits her figures now, not a successor’s down the line.
Trusts are a way to pass on wealth and beat inheritance tax that have been used for years by wealthy families.
But the rules have been tightened on these and they can incur tax charges, particularly if you want to keep some control over funds.
You usually cannot continue to benefit from what has gone into it, then still expect your beneficiaries to avoid inheritance tax.
Anyone considering using a trust should seek professional financial advice.
Other ways to cut inheritance tax include giving to charity and taking our life insurance policies in trust to settle eventual bills.
> Read our full guide: Ten ways to legally avoid inheritance tax