AllAboutFinanceCareers Finance jobs, courses & advice. All good. All in one place.

Inheritance Tax: Keep, Abolish, or Reform?

06/02/2020

For years, inheritance tax—commonly referred to as the “death tax”—has been a political football in the UK. Suggestions have ranged from abolishing inheritance tax altogether to getting rid of the whole concept of inheritance. So how should we proceed with this thorny issue?

Inheritance Tax: Keep, Abolish, or Reform?

Approximately 590,000 people die in the UK each year and 275,000 complete inheritance tax forms, yet the levy is paid by just five percent of UK estates and makes up less than one percent of the total taxes collected. Despite these figures, inheritance tax remains one of the most debated and unpopular types of taxation in the UK. According to a 2015 YouGov poll, 59% of UK citizens of all parties regard the inheritance tax as unfair. 

Is the ability to leave assets to the next generation an important right, and if so, at what level should it be capped? Is the desire to raise the threshold merely an expensive way to bribe older and richer voters, and what are the implications for the economy? 

Inheritance tax: unpopular and unfixable?

Inheritance tax (IHT) is a tax on the bequeathed estate (the property, money, and possessions) of someone who has died, rather than the person who inherits. Although beneficiaries do not normally have to pay tax on their inheritance, they may have related taxes to pay, such as rental income earned from a house left to them in a will.

In the UK, inheritance tax is levied at a rate of 40% for incomes above £325,000 or £650,000 for a couple, with new allowances enabling £1m in property to be transferred. Some gifts given while the person is alive may be taxed after their death, although depending on when the gift was given, if taper relief applies, the inheritance levied on it will be less than 40%. The estate can pay inheritance tax at a reduced rate (36%) on some assets if the will specifies that 10 percent or more of the net value of the estate will be given to charity.

Many advisers note that the inheritance tax thresholds have not kept pace with inflation. The nil-rate band was set at £325,000 in 2009-10 and is frozen until 2020-21, despite the fact that many believe that the band should have been raised to £500,000 rather than introducing an additional residence nil-rate band in 2017. The additional band enables a couple to pass on a family home up to £1m tax-free to their direct descendants. However, as house prices have risen dramatically in London and the south east, the value of family homes could start to push many estates over the tax-free limit. 

While some say this change may have somewhat lessened inheritance tax liability, it has also made IHT even more complex. This added complexity could push more executors to rely on advisers rather than create a simplified system that a layperson is able to navigate without too much trouble.

Some experts say a progressive inheritance tax system is necessary to prevent privilege from being automatically transferred from one generation to the next, creating what business magnate Warren Buffett once called an “aristocracy of wealth.” There are growing calls from left-of-centre politicians in the UK and around the globe to use wealth taxes to create an economically fairer world, meaning that although inheritance tax faces nearly universal hostility, it could actually be part of the remedy for income equality and the UK’s looming tax crisis. 

Former Prime Minister and “People’s Budget” champion David Lloyd George once said: “death is the most convenient time to tax rich people.” However, many oppose inheritance tax because it is considered a middle-class tax, since the rich can avoid it by giving their assets away and paying financial advisers to find ways around it. Consider this reader’s comment made in response to a recent Financial Times article on inheritance tax: Inheritance tax is a wholly voluntary tax. Ask any specialist tax lawyer or accountant. The UK’s annual £5bn IHT bill is only paid by the wealthier middle classes, who have less ability to avoid it through planning. Virtually none is paid by the very wealthy in the UK.”

Any gifts made at least seven years before an individual’s death will not be taxed, prompting many wealthy individuals to gift their resources in advance. Exemptions for agricultural land and unquote business assets provide additional opportunities to dodge paying inheritance tax. After reliefs, it is possible to inherit up to £900,000 from a parent without paying any tax at all—more than a lifetime’s worth of earnings for many low and middle-income earners in the UK.

Should inheritance tax be reformed or abolished?

At a recent Conservative Party Conference, Chancellor Sajid Javid said he was considering doing away with the inheritance tax completely. “I do think when people have paid taxes already through work or through investments—capital gains and other taxes—there is a real issue with then asking them, on that income, to pay taxes all over again.” However, double taxation is not unheard of—citizens of the UK routinely pay value-added tax (VAT) on eligible goods and services bought with taxed income.

Proposed changes to the IHT

Because of the unpopularity of inheritance tax among both parties, the left as well as the right have proposed reform and there may be major changes ahead for what has been termed “Britain’s most hated tax.” Here are some of the ideas that have been circulating throughout the UK:

Abolish and replace. The Institute for Public Policy Research (IPPR) has suggested getting rid of IHT and enacted a lifetime donee-based gift tax in its place. By levying a tax on the recipients rather than the estate, backers of the proposal say the “double dipping” objections would be diminished in favour of what they believe to be a fairer method of taxation. Under this system, a new tax would be imposed on any gifts received by an individual above a lifetime allowance of £125,000. After this, individuals would be taxed annually at the same rate as income from labour (except for gifts between partners). The IPPR estimates that the measure would raise £15bn in 2020/21—£9.2bn more than the current system.

Tax inheritance as income. Going along with public opinion regarding inheritance tax, it might be preferable to tax those fortunate enough to receive large inheritances rather than those who decide to give rather than spend their money. The Organisation for Economic Cooperation supports the idea that inheritance tax could be a way to decrease wealth inequality and reallocate between the generations, and favours taxing inheritance as income because it “weakens the objection that the donor’s income is being taxed twice,” according to one Guardian report.

Reform the gifting rules. The Office of Tax Simplification (OTS) has suggested reforming the gifting rules to solve the inheritance tax issue. At present, an individual can gift up to £3,000 a year free from inheritance tax, plus £1,000 for wedding gifts (more if you are related to the bride or groom). You can also make small gifts of up to £250 tax free, but if you give away more than that you’ll likely be subject to a 40% inheritance tax when you die. To simplify the inheritance tax system, the OTS has proposed the following changes:

  • Scrap all the current gifting rules and create one single “personal gifting allowance.” 

  • Reduce the seven-year rule to five years.

  • Do away with the sliding inheritance tax scale as well as the 14-year rule that requires lifetime gifts go into a trust that is subject to inheritance tax.

  • Remove the tax on death benefits from insurance policies so that those funds would no longer need to be held in trust to avoid inheritance tax.

Detractors to this plan say that while review is needed, simplification to the system also risks that reliefs and exemptions will be cut or restricted in some way.

Tax the recipients, not the donors. According to a report from the independent British think tank The Resolution Foundation, the inheritance tax should be abolished in favor of a broader levy on recipients of gifts and bequests that would be fairer and more difficult to avoid. Many view the inheritance tax as the most unfair form of personal taxation, and Resolution Foundation says that this is due in part to the high, flat headline rate and the perception that it is a tax on giving. According to the foundation, a fairer alternative and one that could actually raise more money at lower rates would be a tax on lifetime receipts from gifts and bequests, which is already in effect in France and Ireland. According to the Resolution Foundation’s proposal:

  • £3,000 worth of gifts from one donor to one recipient each year would be exempt. 

  • Recipients would have a lifetime allowance of £125,000, and anything above that would be taxed at a basic rate of 20%.

  • A top rate of 30% would be established for receipts over £500,000.

If this proposal was introduced in 2021, it would potentially raise potentially £4.8bn more that the projected receipts from inheritance tax that same year, with gains increasing over time. According to the foundation, taxing recipients is seen as “politically easier” than taxing donors and would encourage donors to share their wealth more widely.

Is inheritance overrated?

According to the Resolution Foundation report, the forecasts for inheritances should be viewed in the context of existing high wealth inequality, particularly among young people. Among older millennials who were born between 1981 and 1985, the top 10% owned 54% of the group’s net wealth at age 30. With the growth of wealth having overtaken income in the UK, gaps in wealth have become even more difficult to overcome through earnings alone, and the fact that some have far more luck in this “birth lottery” than others is one of the main reasons why the UK has chosen to tax inheritances in one form or another. 

Although many people believe that the only way to become rich today is through inheritance, more and more are coming to the realisation that wealth should instead be transferred from the “haves to the have nots” via charitable donations. Some even go so far as to say that there is no incentive-based argument for letting people inherit wealth; in fact, a sudden windfall could potentially greatly reduce someone’s appreciation for the value of hard work. 

A recent Coldwell Banker report estimated that $68 trillion will be passed down from one generation to the next in the coming decades, but people like Buffett, Bill Gates, and most recently Ashton Kutcher clearly don’t plan to be part of the Great Wealth Transfer. These wealthy Americans (and others like them) have said they don’t favour creating trust funds for their already-successful children, insisting the money could be better spent elsewhere, such as by donating it to worthwhile charities. After all, they say, allowing children who are already living a privileged life thanks to their parents’ wealth to benefit again only magnifies the inequality.

Inheritance plans aren’t just changing among celebrity circles: the percentage of retirees who plan to leave an inheritance to their heirs is on the decline. According to Natixis U.S. Investor Survey, only 40% of all baby boomers are planning to leave an inheritance, despite the fact that 68% of their millennial children are expecting one. This seems to signify many families’ reluctance to discuss money. It also adds a grain of truth to the slogan displayed on many retiree hats and t-shirts: “I’m spending my children’s inheritance.”

Jan Hill

Recruiting? We can help