Make the most of death duty exemptions

AN EXTRA 7,500 families will drop out of the inheritance tax net on 6 April when the minimum size of estate affected rises from pounds 154,000 to pounds 200,000, writes Paul Slade.

That is the good news. The bad news is that inheritance tax will still catch many families who would certainly not consider themselves rich. But proper financial planning can considerably reduce the bill your heirs will face.

Inheritance tax affects not only bequests made when you die, but also gifts made within the final seven years of your life.

The first step in inheritance tax planning is to make any gifts to your beneficiaries as soon as possible. Until your death, these gifts will be treated as "potentially exempt transfers".

If you die within three years of making the gift, your estate will pay inheritance tax at the full rate of 40 per cent. The tax payable then tapers off as shown in the table below.

Gifts from one spouse to another are completely exempt from inheritance tax. Many people will write their wills so as to transfer all money to the surviving spouse, who will then make a bequest to the children. But taking this route wastes the pounds 200,000 tax-free allowance.

Lynn Melvin, senior estate planning manager at Midland Private Banking, says: "We encourage couples to use the nil-rate band on the first death if it's possible to do so without impacting on their lifestyle."

In practice, this means the first spouse to die passes money directly on to the children orto a trust that will manage it on their behalf. The trust could be written in such a way as to give the surviving spouse an income too. "As long as it does not go outright to the surviving spouse, then you're not wasting the nil-rate band," Ms Melvin says.

There is an annual exemption of pounds 3,000 so that, for example, a couple with children could each give up to pounds 3,000 a year tax-free. Any unused part of your pounds 3,000 annual exemption can be carried forward, but only for one year.

In addition, you can make individual gifts of up to pounds 250 a yearwithout attracting tax liability.

Gifts to UK-registered charities are also exempt as is any reasonable expenditure for the education of your children or care of dependent relatives.

The asset that brings most people within the inheritance tax net is the family home. One answer may be transferring ownership to your children.

Unfortunately, the Revenue will accept the transfer as potentially exempt only if "possession and enjoyment" of the property moves from you to your child. If you continue to live in the house, it will still be treated as part of your estate on your death unless you pay your beneficiary a reasonable market rent for living there.

Inheritance tax tapers off

Years between Percentage of tax Effective rate

gift and death at higher rate charged

0-3 100 per cent 40 per cent

3-4 80 per cent 32 per cent

4-5 60 per cent 24 per cent

5-6 40 per cent 16 per cent

6-7 20 per cent 8 per cent.