A picture of a stately home.

Inheritance tax and its discontents

There’s been a lot of talk in the papers this week about inheritance tax. There’s speculation that the Government might cut the inheritance tax rate or even abolish the tax completely. So I thought it might be fun to look under the hood and to consider what inheritance is, how it works (or doesn’t) and how we might do things differently.

Inheritance tax is a tax that is levied on people’s estates when they die. This means their property, the money they have in the bank, any investments they may have, and their possessions. It also includes any major gifts they have given in the seven years immediately prior to their death. It doesn’t, however, generally include retirement savings held within a formal pension plan.

Not everyone has to pay inheritance tax, though. It’s charged at a flat rate of 40% on estates worth more than £325,000. And there’s an additional £175,000 allowance if the estate includes the deceased person’s main residence and that residence is passed to their children or grandchildren.

Furthermore, married couples and civil partners essentially share their combined inheritance tax allowance – known as the ‘nil-rate band’ – so that inheritance tax only becomes due when both partners have passed away. This gives them a combined allowance of £1 million, if their main residence is included in the estate.

Interestingly, inheritance tax is also not normally levied on money or other assets bequeathed to an ‘exempt beneficiary’, such as a charity, a community group or (ahem) a political party.

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Inheritance tax is commonly referred to as Britain’s ‘most hated’ tax. Which is odd, really, because hardly anyone pays it. HM Revenue and Customs (HMRC), who administer our tax regime, say that fewer than 4% of estates have inheritance tax levied upon them. So over 95% of people don’t have to pay it.

Perhaps unsurprisingly, most of the people whose estates pay inheritance tax live in London or the South East of England, where people are more wealthy in general. And (somewhat less unsurprisingly, given the Government’s focus on this topic as it approaches an election with its poll ratings around its ankles), the impact of inheritance tax is – according to the Financial Times – strongest in areas represented by Conservative members of parliament.

The number of estates paying inheritance tax is, however, higher than it has been in the past. This might be due to increased mortality during the pandemic, as HMRC has suggested. But it’s more likely a result of increasing asset values (especially property) and a freeze in the nil-rate band threshold.

Furthermore, the Institute for Fiscal Studies (IFS) – a well-respected economics think tank – suggests, in an excellent report that it has just published on reforming inheritance tax, that the proportion of estates that pay inheritance tax could rise to 7% by 2032/33.

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So why do people seem to hate inheritance tax, if it’s probably not going to affect them or their estate? A common argument is that it’s a tax on money that has already been taxed. But this isn’t necessarily true. An increase in value of one’s main residence (i.e. the family home) isn’t otherwise subject to tax. Neither is growth in the value of investments, unless you sell them.

Perhaps more relevant is the perception that, whilst you are grieving the loss of a loved one (and dealing with the inevitable pile of paperwork and associated cr*p that comes with a relative’s sad demise), all the Government can do is send you a tax demand. The media going on about ‘death duties’ probably doesn’t help, either.

There’s also a perception that inheritance tax has so many loopholes and exemptions that those with the money for lawyers and tax accountants can easily weasel their way out of paying it, while ‘normal working people’ who have managed to do OK for themselves are left to stump up.

I suspect also that many older people are worried that they won’t be able to pass on their house – for which they spent decades diligently paying off the mortgage – to their offspring.

However, I feel obliged to point out at this juncture that, unless you’re the 17th Duke of something-or-other, your kids really don’t want your house and your knick-knacks. By the time you pass away, they’ll have their own home and mortgage and enough tat to sink a battleship. So they’re just going to sell everything and bicker over the proceeds.

The fact remains, though, that talking about slashing or ditching inheritance tax is a sure-fire vote-winner. Even if it will, inevitably, lead to a rise in another tax on something else. Though, presumably, after the election.

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At this point, it’s worth examining why we have taxes in the first place.

Firstly, the Government levies taxes to fund the delivery of public services. They’re essentially way of us clubbing together to pay for things from which we all collectively benefit, like national defence, ambulance services, food safety standards and such like.

Inheritance tax raised £5.76 billion in the 2020/21 tax year. (No, I don’t know why HMRC is unable to provide more up-to-date data, either.) This is less than 1% of total tax revenues for that period, but it’s still a fair old chunk of money. Enough to buy five Type 45 destroyers, for example. Or to build 192 miles of motorway. Or to pay the NHS staffing budget for a month.

The Office for Budget Responsibility estimates that inheritance tax is likely to raise around £7.2 billion in the current tax year. And the IFS says that it could raise up to £15 billion a year by 2032/33, due partly to the ‘snowball effect’ (my term, not theirs) of inherited wealth being passed on to the next generation.

Secondly, taxes can be used to influence behaviour and to achieve desired social impacts. A tax on cigarettes, for example, helps to stop people smoking and reduces the burden on our healthcare services. A tax on petrol makes people drive less and reduces congestion, carbon emissions and pollution.

Inheritance tax obviously doesn’t stop people dying. But it’s essentially a tax on the transfer of wealth. And wealth creates more wealth, which leads to inequality. And so inheritance tax has a role to play – in theory, at least – in tackling inequality and in promoting a fairer and more just society.

According to the IFS, inherited wealth is growing, compared with earned income. And it is doing so predominantly among those who are already wealthy. If we were to abolish inheritance tax, half of the benefit would go to the top 1% of estates by value, each of which has a value of £2.1 million or more. And they would benefit from a tax cut of, on average, £1.1 million each. The more than 90% of estates that do not pay inheritance tax would gain no benefit at all.

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Sure, inheritance tax is far from perfect. The reliefs available for agricultural and business assets, as well as for pension pots, are well-meaning but are open to abuse and provide people with an avenue to avoid inheritance tax. The same goes for the extension to the nil-rate band for main residences passed to direct descendants.

But we should be able to fix these deficiencies if we really want to. We could abolish the agricultural and business reliefs, says the IFS, which would bring in an additional £1.5 billion a year. But this could have a disastrous effect on genuine family farms and businesses, as they don’t tend to have oodles of cash lying around and would need to sell off assets to pay an inheritance tax liability.

Alternatively, we could abolish the £175,000 family home relief and just increase the nil-rate band to £500,000. We’d lose out on some tax income, says the IFS, but it would make the system a little bit more fair. We could also increase the nil-rate band by some measure of inflation each year, to ensure that only genuinely ‘wealthy’ people are subject to inheritance tax.

We could introduce different bands of inheritance tax, with higher tax rates for higher bands of estate value. Like with income tax. So estates would be taxed, for example, at 0% for the first £325,000, 25% for the next £325,000, 50% for the next £250,000 and 75% on anything above that.

Or we could change things a bit more fundamentally and tax estates at the marginal income tax rate of the beneficiary/beneficiaries. So someone paying income tax at the basic rate would pay less inheritance tax on money that they inherit than someone already earning £150,000 a year.

The IFS suggests that we could get rid of inheritance tax completely and tax the individual elements of an estate using other taxes. So assets held at death could be subject to capital gains tax and income tax could be levied on cash drawn from inherited pension pots. (The latter already happens sometimes, but it depends on the age at which the deceased person passed away.)

We could even replace inheritance tax with an annual tax on everyone’s wealth while they are alive. This is an idea that comes in and out of fashion, but the difficult bit we’ve not figured out yet is how people would pay tax on assets that don’t generate income that can be used to pay the tax due.

Inheritance tax is the ideal tax, in this respect. Because it only becomes due when you’re dead and don’t need your money any more. It’s really just a mandated bequest in favour of the public services. (Your heirs may feel differently, of course.)

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The bigger question, though, is whether the inheritance tax regime achieves its social goal of reducing inequality.

The answer, sadly, is far from a resounding yes. According to the IFS, inheritance tax has only a small impact on the value of inheritances passed down through wealthy families. The wealthiest fifth of people leave on average £380,000 to each of their children and pay only around 10% of it in inheritance tax. The least-wealthy fifth of parents, in contrast, leave each of their children an average of just £2,000.

Furthermore, by the time their parents pass away, the children of the rich are themselves already rich. When they are in their fifties, for example, the children of the richest fifth of parents already have personal wealth of, on average, £830,000. The children of the least-wealthy fifth of parents, on the other hand, have an average personal wealth of £180,000.

So if we’re going to combat inequality, inheritance tax isn’t the answer. Or, at least, it’s not the entire answer. But neither is simply abolishing it to get a bump in the polls. Inequality has become ingrained in our society precisely because it’s a complex problem that doesn’t lend itself to simplistic solutions and attention-seeking soundbites.

Some form of inheritance tax may well, of course, be part of the answer. Personally, I’m all for a tax that stops wealth being passed down the generations and, by providing funding for public services, helps to give everyone a fair chance in life. But we need more than that, too.

Most importantly, we need a mature and evidence-based debate about how we’re going to use all the weapons in our arsenal, including the tax regime, to combat the challenges we face as a society.

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Image: Ste Clayton on Unsplash

Disclaimer: I’m not a financial advisor. The information on my blog doesn’t constitute financial advice or recommendation and shouldn’t be considered as such.



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2 responses to “Inheritance tax and its discontents”

  1. Laurence Cox Avatar
    Laurence Cox

    But inheritance tax really hits the moderately rich while leaving the super-rich almost untouched. Taking the Duke of Westminster as an example, when his father died a few years ago he became the principal beneficiary of a Trust worth £9bn. Trusts are taxed on their value at a rate of 6% every 10 years. As the assets of the Trust could be invested risk-free in UK Gilts (currently the yield is 4.442% for 10-year Gilts), one can think of the Trust as paying an effective tax rate of around 14%. In practice, the assets would be invested more widely and the yield would be greater. So, the “elephant in the room” is why are we not talking about taxation of Trusts, which would yield far more than fiddling around with changing the IHT rules.

    1. Simon Perks Avatar

      I couldn’t agree more, Laurence.

      As I mentioned in my post, there are various ways in which those with means can engage in ‘tax planning’ and circumvent the inheritance tax rules. And, as you point out, the use of certain types of trust is a prime example of this. We clearly need a holistc approach to taxing wealth, so that those who wish to avoid paying tax can’t just shuffle their money and other assets from one bit of the tax regime to another.

      On a side note, in terms of why we’re not talking about them more, I suspects that it’s partly because the topic is fiendishly complex (and perhaps a little dry, to most people) and partly because the people who have or benefit from trusts tend to be in positions of relative power. (I’m speculating here, but I doubt I’m wrong.)

      I’ll make a note to look into the topic of trusts in more detail and to explore it in a future blog post.

      – Simon

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