Inheritance tax - robbing the dead, or helping the young?

Most of us hope to be able to leave something to our loved ones when we die. If we have been fortunate in life, that might be a house and whatever is left of our pension pot. Some might leave a great fortune, others might only leave happy memories.

In the UK, like many countries, if you leave a larger-than-average estate, your heirs will most likely have to pay tax on it. In the UK, this is called inheritance tax, or IHT. There are mixed opinions on how fair this is. I will look at some of the arguments in this article.

IHT rules

Here is my understanding of the basic rules of IHT. This isn't meant to be advice, I am no expert, and how the rules apply to your own exact situation might be different. Get proper advice from someone who knows what they are talking about before you make any financial decisions.

The first thing to remember is that IHT is calculated on the total value of your estate, that is, your house, savings, valuables, etc. Whether you are leaving everything to one person or leaving things to 20 people, the total IHT is the same.

The basic rules are:

• Anything you leave to your spouse or civil partner is tax-free.
• For anything you leave to anyone else, the first £350K is tax-free, the rest is taxed at 40%.
• However, if the estate includes your main home, and it is being passed on to a direct descendant (for example, a child, stepchild, grandchild), then the tax-free allowance, including the house, can be up to £500K.
• For a couple, if the first to die doesn't use up their IHT allowance, then it is transferred to the surviving spouse. When they die, their heirs get the benefit of both tax-free allowances.

So, for example, if the first parent dies and leaves everything to their spouse, then none of their tax-free allowance will have been used. This means that, when the second parent dies, the children could inherit up to £1m tax-free, including the house, depending on the exact circumstances. They would pat 40% on anything above that amount.

Is IHT double taxation?

One of the most quoted complaints about IHT is that it is double taxation. The deceased have already paid taxes on all their wealth, and now they are being taxed again.

This, unfortunately, is one of the weaker arguments. There is nothing unusual about paying tax on money you have already paid tax on. For example, you pay income tax on your earnings, but then you have to pay Council Tax (ie property tax) using money that you have already paid tax on. And when you buy anything, you pay VAT (a sales tax), again, an extra tax on money you have already been taxed on. If you choose to buy alcohol, you have to pay alcohol duty, but you also pay VAT on the total price, including the alcohol duty. So you are paying tax on the tax! The same thing happens when you buy petrol.

Paying tax on money you have already paid tax on is not at all unusual. Annoying, but not unusual. I've seen people go through all sorts of mental gymnastics trying to prove that IHT is somehow different. But it isn't.

In addition, of course, it isn't the deceased who is paying the IHT, it is the heir. The money is changing hands, and it is very common for taxes to be applied when money changes hands. If you go to the barber and pay them for a haircut, they pay tax on that money. That is how tax works.

IHT tackles generational wealth inequality

There is nothing wrong with leaving a bit of money to your children and grandchildren. But if someone leaves so much money that their great, great, great, great grandchildren will never have to do a day's work in their lives, then I would say that is not a healthy way to run a society. Giving your children a leg up is one thing. Setting up a dynasty where your progeny will own entire counties forevermore is something very different.

Relative wealth is important. We are all better off than people were 100 years ago, simply in terms of health, education and lifespan for a start. But, however much things have advanced, if you are faced with other people in society who are far, far better off through no effort of their own, then you are poorer than you should be.

Children of the wealthy have already had opportunities in life that the rest os us can only dream of, and will inherit far more than the average person. Rebalancing that, just a bit, as one generation replaces the last, seems like an entirely just and sensible policy.

But is it too little too late?

Should this rebalancing of wealth really wait until the rich person dies? Would it not be fairer and more efficient to make the wealthy pay more taxes while they are still alive? If someone becomes wealthy in their 40s, for example, with average life expectancy of 80+, it might be another 40 years before they pay a penny in IHT (assuming they don't manage to avoid it altogether).

Most "children" are 50+ when they inherit

Life expectancy has increased in recent decades, which, of course, is a very good thing (although it has stalled/gone into reverse in the past few years). As a consequence, many people are in their 50s or 60s when they inherit from their parents. Rather than giving them a start in life, the money they inherit will probably just be topping up their own pension pot.

Of course, that doesn't mean they aren't entitled to inherit. But when people use emotional arguments about passing money on to their children, when in fact those children might be pensioners themselves. It rings a little hollow.

In many cases, of course, the money might actually be used to help give their grandchildren a start in life, which they might well need given the current housing market. But the argument for providing a tax break for doing that seems a little weaker.

The wealthy can avoid IHT, so it is unfair on middle earners

There are various ways to avoid IHT, and while in theory they are available to anybody, in practice they are more accessible to the very wealthy. This is just a general overview. I am not a tax expert, so obviously, do your own research if you plan to do any of these things. There are often all sorts of gotchas in anything tax-related.

Gifts are usually exempt from IHT provided you don't die within 7 years of making the gift. So if someone's estate is likely to be affected by IHT, and if they have money or assets that they don't need, they sometimes give them to their heirs early, while there is still a good chance they will survive 7 years. That is easy to do if you are very wealthy. But for most ordinary people, most of their wealth is in their house and pension pot, so it often isn't possible.

Less drastically, anyone fortunate enough to have a large annual pension can make regular gifts free from IHT. Again, most of us are not in that situation - we need our pension to live on.

There are various tax-efficient ways of passing money on. Trusts are the most famous ones, although the rules have been tightened these days. Passing on business assets is another way, for example, a family-run company might attract less (or zero) IHT when inherited. If you can afford to buy a farm, that can be sometimes be passed on without attracting IHT.

If you are extremely wealthy, you can avoid IHT altogether by ensuring that you are not classed as living in the UK. If you have a private jet and mansions around the world (with staff, of course), you can still spend quite a lot of time here without being required to pay IHT.

Removing IHT would mainly benefit the top 1%

If IHT were completely removed, then half of the savings would go to the wealthiest 1%. So it would be a tax break for the rich, at the expense of everyone else. Also, most of the savings would go to people living in London or the south-east of England. So it would be a tax break for the wealthiest areas of the country, at the expense of the poorer areas.

This might seem like a contradiction. If the very wealthy are avoiding IHT, why would they benefit so much from its removal? Well, they are still paying some IHT, but they are avoiding most of it. If the estate of a multi-billionaire pays a fraction of 1%, that is still a lot more than the estate of a multi-millionaire paying 40%. But, arguably, it is not as much as it should be.

How could IHT be improved?

IHT, as it currently stands, takes a large chunk of the inheritance of the moderately wealthy, typically people with estates of a few million. It is largely avoided by people with much larger estates. How could it be made simpler and fairer? There have been several suggestions:

• Lower the rate to, say, 10% but apply it to everybody (removing the IHT free band). That would make people less likely to engage in complex schemes to avoid the tax. But on the negative side, someone inheriting a modest house but no cash might be forced to sell the house to be able to pay the 10% tax bill.
• Shorten the 7-year rule. Currently, gifts are potentially exempt from IHT, provided the donor lives for a further 7 years. That seems quite random and unfair, someone might be in good health right now, but could die suddenly in a few year's time. A shorter time (5 years, or even 3) might be fairer.
• Get rid of the special rules relating to family homes and relationships. Have one fixed allowance (for example, £500k), no matter who inherits, and no matter if the value is a home, cash, or anything else. That would be fairer to people who don't own their own home or have a non-traditional family structure.
• Tax the person receiving the inheritance, rather than the estate. So if someone has a £2m estate, but 5 children, there would be no tax to pay. But if one person has several large inheritances from different people, they would have to pay extra tax.
• Tighten up on some reliefs. For example, some people buy farmland that isn't in use, and can use Agricultural Property Relief to avoid tax. That relief is intended to help genuine farming families. The rules could be tightened to enforce that.

My view

This is a complex and emotive topic. But my view is that, when someone receives a significant inheritance, then it is reasonable for them to pay some tax on that inheritance, exactly as they do when they receive money from other sources.

It seems reasonable that someone should be able to inherit an ordinary family home and a few savings from their parents, without paying tax. But anything beyond that should be taxed fairly, and we should ensure that the very wealthy pay their fair share as well.