Autumn Budget: how Labour might change IHT

When it comes to placing bets on which taxes the chancellor will raise in next week’s budget (October 30), inheritance tax is a clear contender.

Latest HMRC statistics show that the Treasury raised £4.3bn from this tax in the first half of this financial year - up by 10.3% on the same period the year before, so it seems likely the Chancellor Rachel Reeves will be looking to further increase this.

The perception might be that this is a tax primarily aimed at wealthy landowners — so an obvious choice for an incoming Labour government looking to put the nation’s finances on a more even keel. But a closer look at how IHT works and who actually pays it shows that the reality is a little different.

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So what might change? The increase in IHT tax receipts has been largely due to the fact the main thresholds at which IHT is charged on estates have remained frozen for years - so as house prices and other assets have risen in value, more families are subject to this inheritance tax.

It's highly likely Reeves will keep the main IHT thresholds on hold for the foreseeable future - and may possibly even reduce them, particularly the one relating to the value of the family home.

Although no-one is predicting that Reeves will increase the IHT rate (currently 40%) she is expected to remove a number of IHT exemptions and change the rules around gifts to boost the overall tax take.

Pensions, for example, are widely expected to be brought into the IHT net, while people giving assets away may have to live significantly longer before they are excluded from their estate for tax purposes.

This could have a significant impact on IHT and estate planning for wealthier families. One of the main criticisms of the way IHT is currently structured is that those with serious wealth can take advantage of complicated tax planning options, which are not viable for families whose only asset of significant value is the family home.

However, it's worth remembering most 'ordinary' families are not hit by this tax. Under current rules families can effectively pass on assets worth £1m to their children IHT-free, with just 4% of estates paying IHT in 2020/21.

IHT threshold and rates

No tax is charged on assets left to a spouse or civil partner, regardless of value — making marriage one of the most effective ways of reducing IHT.

When the first of the couple dies, their IHT allowance — including the residence nil-rate band if applicable — can be passed to the surviving spouse, and both used together on the death of the second partner.

IHT is then only charged (at 40%) if the value of your estate that exceeds the nil-rate band, which currently stands at £325,000 - a level which hasn't changed since 2009.

However, many people also benefit from an additional 'residence nil-rate band' - set at £175,000. This is designed to help families where rising property prices have brought them into the IHT net. This allowance only applies to those leaving property to direct descendents.

When added to the nil-rate band, this gives a threshold of £500,000 per person. This enables a married couple (or civil partners) to leave £1m to children or grandchildren before IHT is applied. It is possible Reeves may seek to reduce this additional allowance, introduced by a Conservative administration, as this would be an effective way to raise IHT receipts. It is worth noting, though, that currently this residence nil-rate band tapers once an estate exceeds £2m.

IHT gifts

Gifts made during your lifetime can also significantly reduce the value of your estate — although much depends on the timing of these gifts, their value, and purpose. It is widely expected that Reeves will make some changes to these gift rules.

The main exemption is known as a ‘potentially-exempt transfer’.

These can be used for gifts of any size — and provided the donor lives a further seven years, they will not be included when calculating the size of their estate for IHT purposes.

If you die within this seven-year period, a taper is applied, so the gift will be subject to IHT, but potentially at a reduced rate. Even living for a further three years can reduce IHT liabilities.

There is speculation this will be increased to 10 years, with changes made to the taper. Reeves could also introduce a limit on the maximum value of a single potentially exempt transfer (PET) or set a new 'lifetime limit' on how much in total can be given away effectively IHT-free.

Changes could also cover gifts made into trusts, which may be seen as less of a tax grab from 'ordinary families' whose home puts them into the IHT bracket.

Introducing an overall gift limit, could also cover other gift exemptions for smaller sums. Under current rules individuals can gift up to £3,000 a year, and also make unlimited smaller gifts up to £250 per person. There are also exemptions covering gifts to registered charities and paying for a child (or grandchild’s) wedding. With all of these, there is no requirement to live for a specified number of years before the gift becomes IHT free. Changes to these smaller gift rules is unlikely to raise significant amounts of additional revenue under IHT.

IHT exemptions

It is widely expected that the Chancellor will remove some of the current exemptions on IHT.

Pensions: One of the most likely changes is around pensions, which currently do not form part of an estate for IHT purposes. This exemption probably made sense when most people relied on final salary pensions, or bought an annuity which pays an income for life, but ceases when the individual dies.

But pension freedom rules mean more people now take an income from SIPPs or other defined contribution pension funds. This has made pensions an extremely tax-efficient way to pass on assets to the next generation - which is not what they were primarily intended for. Bringing them into IHT could address this issue, as well as raising significant sums for the Chancellor.

Investments: Reeves could also re-examine the exemption for investors who hold shares listed on the Alternative Investment Market (AIM). Provided shares in these smaller companies are held for two-years these are free of IHT. Reports say removing this exemption could raise £1bn for the Treasury.

Farmland and business assets: There are also IHT exemptions for business and agricultural assets, including farmland. Again these exemptions could be scrapped, or new upper limits imposed restricting maximum benefits. The National Farmers' Union has argued that removing agriculture property relief (APR) would only raise £120m a year - but could result in many farms being sold and split up to pay the tax, potentially impacting food production in the UK.

Can you protect yourself from IHT changes?

It is never a good idea to make significant changes to your investments based on speculation of what may, or may not be, in a budget. However, if you have significant assets, it is always worth seeking independent advice on tax planning, which may include IHT considerations. Be wary of giving away assets you may later need or setting up expensive trust arrangements, which can be unwound and may end up costing more than the tax saved.

Our latest Autumn Budget analysis 

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• Autumn Budget: how Labour might change pensions
• Autumn Budget: how Labour might change CGT

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.