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As we approach April 2027 (when unused pension funds will form part of the estate for IHT purposes) the need for effective IHT planning has never been greater. Many clients will be seeking guidance on how best to manage their wealth and legacy.
A powerful yet often overlooked strategy is to include a gift to a registered charity in a will. This simple act will not only leave a positive legacy but can help to reduce the IHT burden on the client’s estate.
There are two ways in which charitable legacies can reduce IHT:
- The charitable gift is exempt from IHT – thereby reducing the taxable value of the estate
- Where 10% or more is left to charity, the rate of tax applicable to the taxable estate is reduced from 40% to 36%.
By understanding the ‘10% test’ you can help your clients ensure their legacy benefits their loved ones and charitable organisations, all whilst optimising the IHT efficiency of their estate.
The 10% test
Let’s see how the 10% test operates by sharing a couple of examples. Before we delve into the calculations, it is important to clarify some key terms that underpin inheritance tax calculations involving charitable legacies:
Survivorship component – joint assets (joint tenancy) that pass automatically to the surviving co-owner.
Settled property component – assets for which the deceased was beneficially entitled to for example the life tenant of a qualifying interest in possession trust.
General component – the rest of the estate except the survivorship and settled property components as well as any property for which a gift with reservation (GWR) exists. This will include unused pension funds from April 2027.
Available nil-rate band – Currently £325,000, increased by any transferable nil-rate band (TNRB) but reduced by previous chargeable lifetime transfers (CLTs) in the 7 years prior to death. This does not include any residential nil-rate band or transferable residential nil-rate band that might be available on the estate.
Donated amount - the amount gifted to charity in the will.
Baseline amount – the figure used to test whether the 10% threshold has been met. It is calculated in three steps:
Step 1 - Establish the chargeable transfer for each estate component.
Step 2 - Deduct the appropriate proportion of the available nil-rate band.
Step 3 - Add back the charitable legacy deducted at step 1 to arrive at the baseline amount.
Examples:
Sarah died on 17 June 2024, leaving an estate valued at £800,000 after liabilities. She left a legacy of £70,000 to the National Trust.
|
Estate on death |
£800,000 |
|
Minus charitable legacy (donated amount) |
- £70,000 |
|
Chargeable transfer (step 1 amount) |
£730,000 |
|
|
|
|
Minus nil-rate band |
- £325,000 |
|
Step 2 amount |
£405,000 |
|
|
|
|
Add back the charitable legacy |
+ £70,000 |
|
Baseline amount (step 3 amount) |
£475,000 |
The donated amount of £70,000 comfortably exceeds 10% of the baseline amount of £475,000 (£47,500), which means the estate qualifies.
Sarah’s estate therefore pays £145,800 (36% of £405,000) in tax rather than £162,000 at full rate (40% of £405,000) – a saving of £16,200.
David died on 17 July 2024 leaving an estate valued at £850,000 after liabilities. He left a legacy of £50,000 to Cancer Research UK. However, his earlier £200,000 gift to his daughter 4 years before he died reduces the available nil rate band, changing the calculation:
|
Estate on death |
£850,000 |
|
Minus charitable legacy (donated amount) |
-£50,000 |
|
Chargeable transfer (step 1 amount) |
£800,000 |
|
|
|
|
Minus nil-rate band |
- £125,000 (£325,000 - £200,000) |
|
Step 2 amount |
£675,000 |
|
|
|
|
Add back the charitable legacy |
+£50,000 |
|
Baseline amount (step 3 amount) |
£725,000 |
In this case, 10% of the baseline amount is £72,500, so the £50,000 gift falls short, and the estate does not qualify for the reduced rate.
However, the beneficiaries of the estate could correct this by increasing the charitable gift through executing a deed of variation, so that the 10% test is met.
In this example, increasing the gift by £22,500 would still leave the beneficiaries better off due to the tax on the estate reducing by £35,100.
Merging estate components to maximise the saving
Where one component of the estate qualifies for the reduced rate of 36% it is worth reviewing whether two or more components (including the one which qualifies) should be merged. Once merged, the charitable legacy within the merged components is tested to see if it now meets the 10% test using the combined values. Where it does, all combined components benefit from the reduced rate.
This can be useful where the charitable legacy is significantly above the 10% test in one component of the estate.
For example, if one component’s baseline value is £400,000 of which £100,000 is left to charity then 25% of this component qualifies as a charitable legacy. Should this component be merged with another, valued at £200,000, with no charitable legacy, the 10% test would still be met e.g. £100,000 / £600,000 = 16.67%.
This means that both taxable elements of the two merged components benefit from 36% IHT rate saving £8,000 (£200,000 * 4% reduction in rate).
Summary
Estate planning can be complex, and some estates will benefit more than others by leaving a gift to charity in a will. Advice is clearly critical to ensure the requirements are met and avoid the need for post-death variations.
Regularly updating and reviewing a will is a vital part of good financial housekeeping and should be a routine topic with clients. As interest in IHT planning grows, understanding how charitable giving can reduce tax rates will become increasingly more valuable.
