Little-known IHT trick could let you pass on £975,000 tax free

Thousands could be needlessly paying large inheritance tax bills each year as a once widely used tax loophole has been all but forgotten.

Everyone has a personal IHT allowance – the nil-rate band – of £325,000, above which their estate pays 40pc tax. There is also an additional allowance for passing a family home to direct descendants, now £125,000 and rising to £175,000 by 2020.

In 2007 a new rule made it possible to transfer unused allowances between spouses when one partner died. This gives a widow or widower up to £650,000 in basic IHT-free allowances and £250,000 in additional allowances if eligible.

Before this, to maximise protection from the taxman many people used IHT-exempt discretionary trusts instead. Often referred to as nil-rate band trusts, they allowed people to ringfence up to £325,000 to pass on to their spouse free of tax on their death.

The transfer of allowances has meant this practice has more or less died out. However, widowed spouses who remarry can still use it to give themselves an additional IHT allowance of £325,000, shielding even more from the taxman. Faye Silver of Raymond James, the wealth manager, said this would benefit people who had lost their partner but who could still remarry.

Figures from the Office for National Statistics show that around 1,400 widows and 1,260 widowers remarry each year.

How it works

Margaret is married to Peter. Peter dies and some years later she marries John.

There are no children involved, so the family home allowance doesn’t apply. Peter’s death leaves Margaret with his full basic allowance, giving her £650,000 of IHT protection.

She puts the £650,000 into a discretionary trust for John. On her death, John can add this to his own £325,000 allowance.

John also ringfences his own allowance through a trust, so Margaret can add his £325,000 to her allowance if he were to die first. Now the surviving spouse will pass on £975,000 tax-free.

What’s more, beneficiaries can use this tactic retrospectively.

By using a legal document known as a deed of variation up to two years after death, families can alter a will to be more tax efficient. Rachael Griffin of Quilter, another wealth manager, said such “littleknown quirks in the tax system” were increasingly important as the Government was raking in record sums from IHT – £5.2bn last year – and expects receipts to total £7bn by 2023.

“Navigating the tax system shouldn’t be akin to finding a needle in a haystack. People are entitled to use allowances, even if few people have heard of them,” she said. The Government is consulting on how to make the tax and trust rules more transparent.