Give to your family, not the taxman

Of all the taxes eating into your hard-earned cash, inheritance tax (IHT) - paid on your wealth above a certain value when you die - is potentially the easiest to avoid. But there are steps you need to take, and it's good to plan well in advance.

The whole issue of IHT was made much more straightforward for most people in 2007, with the introduction of what's known as the transferable nil-rate band for married couples and civil partners.

Each of us has an inheritance tax-free allowance called the nil-rate band; it's currently £325,000 and is frozen at that level until 2015. The new rules mean that when the first partner dies, any unused nil-rate band can be transferred to the surviving partner rather than being lost forever. (Before 2007, married couples had to set up a special discretionary trust to protect the nil-rate band of the first to die.)

Married couples can therefore have as much as £650,000 of wealth before they run the risk of an IHT charge. Only around 16,000 estates paid IHT in the 2010/11 tax year - less than half the number affected in 2006/07 - as a result of the change.

But of course, many people, whether single or married, do have total assets worth more than the nil-rate band, which could potentially be taxed on their death. If you're one of them, what should you do?

It's important to remember that the IHT on your estate will never be your problem - you'll be past caring by then, and your beneficiaries will be the ones sorting out the tax bill. So your chief concern should not be to minimise the next generation's tax liability, but to ensure you have enough money to see you through old age, including possible long-term care.

If you go to a specialist financial adviser - and this is an occasion where expert advice could make all the difference - they will probably put into place a cash-flow model. That will show how much income you need now, how you could generate more in the future if necessary, and what, if anything, could be given away to minimise the value of your estate above the nil-rate band.

Assuming you're healthy and you feel you can afford to try to reduce the size of your estate, the first step is to give assets away to your loved ones. But do make a plan before you start, says Stephen Page, a director at financial planning firm Page Russell. "The big risk is that you give away the investments that are producing your present income or could be used for an income if you need more in the future," he warns.

Some gifts are treated as tax-exempt, so they are immediately outside your estate. Whatever you give away, make sure you keep a formal record of your gift to keep the taxman happy. That means writing to each recipient to tell them this is an outright gift - and keeping a copy of each letter.

So, if you've constructed your cash-flow model to take account of all your future needs and used up your exempt gift allowances, but still have cash to spare, what can you do?

The straightforward solution is simply to give assets away to whomever you want. Such gifts are known as potentially exempt transfers (PETs), which means you need to live another seven years for them to be considered to be entirely outside your estate by the taxman.

If you're concerned about giving them straight to the beneficiaries, perhaps because they are young and irresponsible, you could put your gifts into a discretionary trust. They will still take seven years to disappear from your estate, but that way you can retain some control over how the gifts are managed and when and to whom they are distributed.

But Page says this may be a risky strategy for anyone with assets hovering around the nil-rate band level, because again they may find they need the cash to boost their income in later years. He suggests instead that they give a share of their home direct to their children, and pay them a market rent to reflect the fact that they are living in the children's share of the property.

"Not only will the gift be outside the estate in seven years' time, but in the meantime the rent paid also amounts to a transfer of income to the kids," he explains. "It's better for a retired person to have cash in the bank and less property to worry about maintaining."

Another alternative to a straight PET is to use a product called a flexible reversionary trust. As Christine Morris, a financial planner with Informed Choice (South West), observes, although the capital remains in your estate for seven years, investment growth is removed from the outset. "Additionally, there's a degree of income flexibility, with the option to receive 'maturities' each year," she adds.

They're complex products, but one advantage is that they can invest in any fund, so the holdings can be matched to your risk profile. But you'll need at least £60,000 to invest, and you'll pay an initial fee and a small regular admin charge as well as the underlying fund charges.

Wealthy investors have a wider choice, with various schemes investing in assets such as AIM (Alternative Investment Market) shares, forestry and enterprise investment schemes. These qualify for business property relief and therefore fall out of your estate as far as IHT is concerned after you've owned them for two years. But they're only appropriate if you have £1 million plus in liquid assets on top of the value of your home.

THE BEST WAYS TO GIFT YOUR MONEY AWAY

Gifts out of normal expenditure

One option, often overlooked but invaluable if you have more money coming in (from paid employment, pensions or investments) than you actually need, is to make monthly or annual gifts out of regular income.

You can give away as much as you want this way, provided it doesn't affect your normal lifestyle. "It's a very good option, especially if you have an index-linked pension or income that keeps pace with inflation," says Page.

Annual gift allowance

In addition, you're allowed to give away up to £3,000 each tax year to one or more people. If you didn't use the previous year's allowance you can carry that forward to the next tax year too. So couples starting to make use of their annual allowance can give away up to £12,000 in the first tax year they start using it.

Small gift allowance

You can also gift up to £250 each tax year to as many people as you like, though they cannot be the lucky recipients of the annual allowance.

Wedding gift allowance

Another option, less important if you're trying to give away assets on a regular, planned basis, is to make gifts to people who are getting married. The amount you can give depends on your relation to the happy couple: for instance, each parent can give up to £5,000, grandparents and other relatives up to £2,500, and other people up to £1,000. And the bride and bridegroom can give each other up to £2,500.

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