We often think of our estate in absolute terms, but over time, inflation quietly erodes its real value – sometimes more than we realise. Inflation is well known as the cause for rising costs of living, but it is this same force that erodes the value of inheritance that eventually passes to beneficiaries. Whilst the nominal value of every £1 remains consistent (£1 today is £1 tomorrow), the purchasing power (or real value) falls over time. For example, using the Bank of England Inflation Calculator, £100 in 2018 has the purchasing power of £78.23 now, or in other words, £100 in 2018 would now purchase only £78.23 worth of goods. The effect gets worse if the reference point is placed further back in time.
Whilst the effects of inflation erode the real value of many estates, those that are liable for Inheritance Tax (“IHT”) on top of the inflationary effects will be subject to amplified losses in value.
Consider the estate of a widow in 2018. The estate comprises a property and savings, with values of £650,000 and £200,000 respectively. Fast forward to today, the value of the property might be £850,000 and the savings might be £230,000. So, an estate worth £850,000 in 2018 may have grown to £1,080,000 in 2025. If the widow dies in 2025, assuming all tax free allowances are available (totalling £1,000,000), IHT will be paid on the excess of £80,000 at 40% equalling £32,000. Assuming no other liabilities, this would leave £1,048,000 to be distributed to the widow’s children. However, when adjusting for inflation, the real value of this inheritance is actually close to £820,000 relative to the 2018 purchasing power. Despite the growth in nominal value of the estate over 7 years, this purchasing power is £228,000 less than the nominal value of the inheritance and £30,000 less than the real value of the same estate in 2018.
The inflation and IHT issue has been compounded further by the freezing of the Nil Rate Band allowance (“NRB”) for IHT at £325,000 since April 2009. As the nominal value of assets has increased since 2009, the allowance has remained fixed at the same value thereby dragging more and more estates into a taxable position and causing already taxable estates to be liable for more IHT. For some estates, this negative effect was partially reduced by the introduction of the Residence Nil Rate Band in April 2017, which allowed estates that met the conditions to qualify for an additional allowance of £100,000 (now £175,000), however this too has been frozen at £175,000 – the same amount since April 2020 – and not all estates will even qualify for this additional allowance.
So, can anything be done to protect against the persistent effects of inflation and IHT?
By making lifetime gifts, including use of available gifting allowances, the beneficiaries of such gifts can make full use of the greater purchasing power, which is even more powerful if used to purchase appreciating assets. In addition to passing on greater purchasing power now, by surviving for 7 years from the date of the gift(s), the value will also fall out of account from the estate for IHT on death. Therefore, lifetime gifts serve two benefits, by both enriching the beneficiaries with greater purchasing power now and potentially reducing the IHT liability in the future, which in turn ensures more inheritance passing to the beneficiaries.
Incorporating this into the earlier example, if £150,000 of the £200,000 was gifted to the children in 2018 rather than being retained in the estate, the children could make full use of the purchasing power of the £150,000 at that time before its value is eroded. As before, by 2025 the value of the property might be £850,000 and the savings might have grown to £57,500 (using the same multipliers as before), providing a total estate of £907,500. The same allowances would be available but due to successful use of gifting and surviving 7 years, the estate would be below the allowances, so no IHT is payable. Assuming no other liabilities, £907,500 would pass to the children. The real value of this inheritance is close to £710,000, which is £10,000 more than the purchasing power in 2018 after the gift of £150,000 was made. Not only did the children get the benefit of greater purchasing power by receiving the gift in 2018, the estate later benefitted from paying no IHT allowing more to be inherited by the children. In fact, even if the death occurred before 2025, causing the £150,000 to be brought back into account, this would use up that portion of the NRB as if it had been retained in the estate, but there was still a greater benefit to the children by receiving the gift earlier than on death.
As explained in this article, there can be significant advantages to making lifetime gifts for mitigating both the effects of inflation and IHT. However, there are many other factors that should be considered before making any gifts and it may not be appropriate in all circumstances. Furthermore, whilst this article has given particular focus to gifting cash (which is most susceptible to the effects of inflation), it may be beneficial to explore gifting other assets through different methods or structures and weighing all options with applicable costs and taxes.
If you would like any assistance with your Wills and Estate Planning, please do not hesitate to contact one of the Tax and Estate Team.
