What is inheritance tax and why might Reeves target it in her budget-

Speculation is growing that next week’s budget announcement could introduce significant changes to inheritance tax (IHT) aimed at generating billions in revenue. Currently, only about one in 20 estates in the UK incur IHT, but the topic consistently evokes strong opinions. Some think tanks argue that existing loopholes allow wealthy individuals to avoid their fair share of tax, while groups like the TaxPayers’ Alliance are urging Shadow Chancellor Rachel Reeves to dismiss any plans to increase this “unpopular death tax.”

So, what exactly is inheritance tax? In simple terms, IHT is a tax levied on the assets left behind by someone after their death, but only if those assets exceed a certain threshold. The standard IHT rate is 40%, applied to the portion of the estate above the current tax-free limit of £325,000. However, the tax rules can be quite complex, featuring various allowances and exemptions, including those for agricultural land, certain business interests, shareholdings in AIM-listed companies, and pensions, which can significantly reduce or even eliminate tax liabilities.

In the 2021-22 tax year, approximately 27,800 estates were subject to IHT, capturing around 4.39% of all UK deaths for that year and generating £5.99 billion in tax revenue. However, the primary IHT threshold has remained frozen since 2009—set to stay that way until at least April 2028—resulting in more individuals becoming liable for IHT due to increases in property values and asset appreciation—a situation known as fiscal drag. The government received a record £7.5 billion from IHT in the 2023-24 fiscal year.

While the average tax paid by estates subject to IHT was £215,000 in the 2021-22 period, that figure is skewed by the amounts paid by the wealthiest individuals. Although the headline rate is 40%, various allowances mean the effective average tax rate for those affected was closer to 13%. This discrepancy suggests that many who advocate for reform believe substantial revenue could be generated by adjusting the current system.

What changes might we expect from the Chancellor? Reeves could potentially alter the various exemptions and allowances, such as those related to spouses and civil partners. Under current regulations, you can bequeath your home to a spouse or partner without incurring any IHT. Moreover, the residence nil-rate band (RNRB) of £175,000 increases the tax-free allowance if you leave your home to your children or grandchildren. As a result, a married couple can effectively pass on up to £1 million tax-free to their heirs after both have passed.

Official data indicates that in the 2021-22 year, surviving spouses and civil partners received £15.5 billion free of IHT, marking it as the most significant exemption available. Sarah Coles, head of personal finance at Hargreaves Lansdown, noted that if these rules were amended, the surviving partner might only be able to leave up to £500,000 tax-free, potentially pushing many London homeowners into IHT territory.

There’s also chatter about potential changes to the rules surrounding gifts. Presently, individuals can give away up to £3,000 each year without affecting their estate’s value for IHT purposes. The rules governing “potentially exempt transfers” allow for larger gifts to become exempt as long as the giver lives for seven years after the transfer. Speculation exists that this seven-year period could be extended to ten years, impacting how future tax liabilities are assessed.

Changes could also come for investors in AIM stocks, which currently enjoy 100% IHT relief if held for at least two years. Experts suggest that this exemption may be reduced or eliminated entirely, potentially yielding more than £1 billion annually in additional tax revenue.

Moreover, there’s concern that the government may target IHT exemptions associated with family farms. Both business property relief and agricultural property relief can currently reduce the value of assets subject to IHT by up to 100%. In the 2021-22 tax year, approximately £4.5 billion worth of assets benefited from these reliefs. If the government implements caps on these reliefs, any values exceeding the cap would be taxed at the standard IHT rate.

Lastly, there’s speculation about potential changes affecting pensions, which currently fall outside of IHT. Introducing IHT or a death levy on pensions could bring additional individuals into the tax net, generating significant revenue for the government, as noted by Helen Morrissey, head of retirement analysis at Hargreaves Lansdown.