Speculation is intensifying that next week’s budget could include sweeping changes to inheritance tax designed to raise billions of pounds.
Only about one in 20 UK estates now attract inheritance tax (IHT), but it is a topic that always arouses strong feelings. Some thinktanks say there are loopholes in the rules that allow the well-off to avoid paying their fair share and which need to be closed, while others such as the TaxPayers’ Alliance have urged Rachel Reeves to rule out increasing this “hated death tax”.
What is inheritance tax?
Put simply, it is a tax paid on someone’s assets (property, possessions and money) after they die, but only if they leave enough to go above a certain threshold.
The standard IHT rate is 40%, and it is only charged on the part of the estate that is above the tax-free threshold, which is now £325,000.
However, the rules are complex: there are various tax-free allowances and reliefs, plus exemptions for things such as agricultural land, businesses, shares in companies listed on the Aim stock market and pensions.
These will often minimise the IHT bill or mean there is nothing to pay.
Who pays it?
In the 2021-22 tax year, 27,800 deaths resulted in an IHT bill, which was 4.39% of all UK deaths that year. The tax raised £5.99bn that year.
However, the main IHT threshold has been frozen at £325,000 since 2009 and is due to stay at that level until at least April 2028, so rising house prices and the increasing value of people’s investments and other assets are gradually pulling more people into the IHT net – a phenomenon known as fiscal drag. In 2023-24, the government raked in a record £7.5bn from the tax.
The average amount of IHT paid by all taxpaying estates in 2021-22 was £215,000, but that was pulled up a lot by the bills imposed on the very wealthiest estates.
And despite the headline rate being 40%, the various allowances and other ways of bringing down the liability mean the average rate paid by those affected in 2021-22 was actually a third of that: 13%.
This may help explain why some of those backing a shake-up believe there are billions that can be raised by making changes to the system.
What might the chancellor do?
Reeves could make changes to the various exemptions, allowances and reliefs currently available: for example, the tax breaks relating to spouses and civil partners.
You can leave your home to your spouse or civil partner when you die, and there is no IHT to pay.
However, there is also something called the residence nil-rate band (RNRB) – currently £175,000 – that can bump up the tax-free threshold if you leave your home to your children or grandchildren.
It all means that, now, a married couple can leave their estate to each other when the first person dies in the knowledge that when their partner dies, up to £1m can be passed on tax-free to their offspring (this £1m is made up of two lots of the main £325,000 allowance – one for each individual – plus two lots of the £175,000 RNRB allowance).
Official figures show that in 2021-22, £15.5bn was transferred to surviving spouses and civil partners on death – the biggest IHT tax break on the books, said Sarah Coles, head of personal finance at investment platform Hargreaves Lansdown.
She added: “If this was changed, instead of the surviving partner being able to give away up to £1m free of inheritance tax, they might be limited to £500,000.” Given that the average house in London was now worth more than that, “it could push the average Londoner into the realms of tax”.
What about gifts?
Yes, there is a lot of speculation that the government may tighten up the rules on “gifts”.
For example, while you are alive, you have a £3,000 gift allowance a year. This is known as your annual exemption and means you can give away assets or cash up to a total of £3,000 in a tax year without it being added to the value of your estate for IHT purposes.
Meanwhile, the “potentially exempt transfer” rules allow someone to give money or gifts of any amount/value to anyone which will become exempt from IHT as long as they live for seven years after giving them. If the giver dies within the seven years and there is tax to pay, the amount due depends on when they gave it – for example, gifts within three years of death are taxed at 40%.
There has been a lot of speculation that the government could, for example, extend the seven years to 10 years.
Changes to this regime “could mean more people receiving gifts and then being stung with a tax bill far further down the line, when they may not have any of the gift left to cover the tax bill”, said Coles.
The government might tighten the rules by taxing gifts over a certain size or introducing a “lifetime limit” on gifts, said Paul Barham, partner and head of international private client tax at Forvis Mazars.
What about investors?
There is talk about a possible change to the rules relating to Aim investments.
Many people in the UK who have invested in smaller companies – which involves more risk – are making use of the current rules that allow 100% relief from IHT on Aim market shares held for at least two years.
“Aim could be excluded from the exemption altogether, the rate of relief could be cut, or the holding period could be increased,” said Coles.
It has been suggested that removing this tax break could raise more than £1bn a year.
Who else might be affected by any changes?
There have been claims the government is planning an IHT “raid” on UK family farms, and is considering scrapping a valuable relief which allows landowners to pass down farms to their children free.
Business property relief and agricultural property relief are tax breaks that can reduce the value of the assets for IHT purposes by up to 100%.
In 2021-22, business property relief was used by 4,170 estates to shelter £2.9bn worth of assets from IHT, while agricultural property relief was used by 1,730 estates to shelter £1.6bn worth of assets.
“At present, each of these reliefs is uncapped, but the government could seek to introduce a cap on the maximum amount of asset value that each relief can be claimed against, meaning any value above this threshold would be subject to the standard 40% IHT rate,” said Myron Jobson, senior personal finance analyst at investment platform interactive investor.
Would any changes to IHT affect pensions?
At the moment, pensions tend to be outside people’s estates for IHT purposes. However, there is speculation that changes are being considered.
Making pensions subject to IHT or a levy on death “has the potential to drag many more people into the taxpaying net and raise some serious revenue for government”, said Helen Morrissey, head of retirement analysis at Hargreaves Lansdown.