Equity release and Inheritance Tax – be careful!

Inheritance tax is a hot topic at the moment. In the Autumn 2024 Budget, the Chancellor announced that pensions will no longer be exempt from Inheritance Tax. The new rules come into force in April 2027, meaning a growing number of people are taking a closer look at the relationship between equity release and Inheritance Tax in an effort to reduce their future tax bill. Unfortunately, for many people, this can be a big mistake.

What’s going to happen to pensions?

In a nutshell, from 6th April 2027, defined pension contributions will be subject to Inheritance Tax. The standard Inheritance Tax (IHT) rate is 40%.

However, it’s worth noting that IHT is only payable when your estate is worth a certain amount. An individual can leave up to £325,000 tax free. If they are married and are subsequently widowed, they inherit their partner’s allowance. This means they can leave up to £650,000 free of tax. Additionally, there is a residential nil rate band (RNRB). This entitles you to another tax-free allowance of up to £175,000. This can be used against your main residence if you decide to pass it on to your children, stepchildren or grandchildren when you die. Again, the RNRB can be passed from one spouse to another, meaning some people can pass on up to £1 million free of Inheritance Tax.

(It is, however, worth noting that the RNRB is reduced by £1 for every £2 that a property is worth above £2 million).

As you can see, while relatively few estates are subject to IHT, many more will be when pensions become subject to the tax. For this reason, some people are looking at the interplay of equity release and Inheritance Tax as a possible method of reducing their future IHT bills.

What is the relationship between equity release and Inheritance Tax?

In theory, equity release could help you to reduce your IHT bill. Equity release can work in two ways. The most common type of equity release is a ‘lifetime mortgage’. This is a loan secured against your home. You repay it – along with interest – when you die or you sell your home to move into long-term care.

The second type of equity release is called a home reversion scheme. This allows you to sell between 20% and 60% of your home in return for a cash lump sum, a regular income (or both). As with a lifetime mortgage, you continue to live in your home. However, home reversion schemes are less popular. This is because you sell the stake in your home for less than its market value.

The theory is that, by releasing money from your property, you can then pass it on to your heirs. If you then go on to live for seven years or more, these monetary gifts become tax free. (Learn more about IHT and gifts).

What’s the catch with equity release and Inheritance Tax?

The main catch with equity release and Inheritance Tax is that you can rarely predict when you die.

If you die within seven years of gifting the equity you’ve released, your heirs will pay some or all of the IHT you’ve tried to avoid.

On the other hand, if you live for many years after releasing equity, you’ll continue to rack up interest on the loan (if you have taken out a lifetime mortgage). This means that, if you live for much longer than seven years, the interest will add up to more than the IHT you’ve saved.

Are there alternative strategies?

There are other strategies you can adopt to reduce your Inheritance Tax bill. One popular method is to downsize your property during your retirement. By buying a smaller property, you can gift the extra money from the house sale to your heirs and there will be no interest payable on it. If you live for seven years after making the gift, no IHT will be payable on it either.

That said, every person’s circumstances are different. That means, IHT advice that may work for one person may not be suitable for you. For that reason, we strongly recommend that you get expert Inheritance Tax planning advice. We can help you with this, so please feel free to get in touch with a member of our team today.