Do you understand inheritance tax, and how it can be reduced? Danny Cox, chartered financial planner at Hargreaves Lansdown, explains.

Inheritance tax (IHT) planning is like trying to photograph toddlers or pets: you are trying to frame an ever-moving target. But with HM Treasury often the chief beneficiary when someone dies (the average amount of inheritance tax paid in 2010-11, per taxable estate, was £165,000), your first question should be: how large will my IHT bill be?

IHT is normally charged at 40% of the value of your estate above a certain amount, referred to as the IHT threshold, or nil-rate band. The 2014-15 IHT threshold is £325,000, and will remain so until 2018. In effect, everyone is a higher-rate taxpayer for IHT purposes. When we say estate, it includes all of your assets, both here and abroad.

Married couples and civil partners can combine their IHT thresholds, meaning that up to the first £650,000 of the estate is free from IHT, as any unused threshold is usually automatically passed on to the surviving spouse.

Reducing inheritance tax takes commitment, and the first step is the cornerstone of any succession plan.

Draw up a will

A formally-drafted will, ensuring the right people benefit from your estate, in the right proportions, and at the right time, is a must. A will also makes the process of administering and distributing an estate after death (probate) far easier. In the absence of a will, your estate becomes hostage to the UK’s unwieldy intestacy laws, which may be contrary to your wishes, and may create IHT liabilities.

After this, you can lower the amount of IHT by reducing the value of your estate that will be subject to tax. This can be done by:

• making gifts from capital or income
• using inheritance tax-efficient investments
• spending capital or income

Gifting

There are 3 types of gift:

• exempt gifts: immediately free from IHT
• potentially exempt gifts: become exempt from IHT over time
• chargeable gifts: may suffer an immediate charge to IHT

Exempt gifts

These gifts are free from IHT, and include gifts to registered charities or political parties. Married couples can also transfer any amount of assets between themselves. In addition, there is an annual exemption. In each tax year, you can make a gift up to the annual exemption of £3,000 to a person, or persons, of your choice.

On top of this, any unused exemption from the previous tax year can be carried forward to the present tax year, but no further. Unlimited gifts from surplus income are exempt, providing they are regular, from income (not capital) and do not affect standards of living. Certain marriage gifts are also exempt.

Parents and grandparents can make one-off gifts on the marriage of children or grandchildren (up to £5,000 and £2,500 respectively). Finally, small gifts of up to £250 can be made to any number of people, completely free of IHT. Gifts to charity in excess of 10% of the taxable component of your estate to a registered charity will reduce the rate of IHT paid from 40% to 36%.

Potentially exempt transfers (PETs)

If a gift is not immediately exempt, it will usually be free from IHT, assuming the person making the gift lives for at least 7 years from the date of the gift. It is important to note that a gift is a gift, and once made, can’t be taken back. So only give away what you can afford.

IHT efficient investments

If held for at least 2 years, certain investment assets qualify for an IHT exemption called business property relief. These assets can be held until death, or even gifted from an estate, without triggering an IHT liability.

This exemption was originally aimed at small business owners, but also includes qualifying shares in unquoted trading companies, such as those listed on the Alternative Investment Market (AIM), which can now be purchases in individual savings account (ISA).

Companies that qualify for this relief, including those listed on AIM, tend to be smaller firms, and their share prices are often volatile and illiquid. They therefore carry a higher degree of risk of losing money than other UK shares.

Pension savings are also usually IHT free and will also be free of other taxes if you die before age 75 (from April 2015).

Spending

The final way to reduce the taxable value of your estate is to spend more on leisure activities. You could take more holidays, or that world cruise you’ve always promised yourself. Dine out and see shows more often. Money you spend in this way won’t be subject to IHT.

However, a word of warning: make sure you leave enough money for you and your spouse to live on, allowing for contingencies, such as paying for long-term nursing care.

The basics of IHT planning are relatively simple, and most people can take effective actions easily. However, for those who are unsure, or where affairs are more complex, seek professional advice from an independent financial adviser.

About the author

Danny Cox is head of communications at Hargreaves Lansdown, and holds chartered financial planner status. For more information, visit the Hargreaves Lansdown website, or follow on Twitter @HLInvest.