Some would like to murder it, but we can live with inheritance tax

The debate over inheritance tax (IHT) is hotting up, with not just the Tories but also Labour luminaries suggesting that it should be scrapped.

It came as no great surprise to hear the Bow Group, one of the UK's most influential right-wing think-tanks, saying IHT should be abandoned in favour of a "land value tax". More unexpected was the recent call from former Labour minister Stephen Byers, urging abolition on the grounds that "it is hurting ordinary people".

Figures from the Halifax illustrate his point. They show that the Government collected £3.3bn in IHT in 2005-06 and is likely to bring in £3.6bn in this tax year. By 2020, it is estimated, this figure will have risen to £5.5bn.

The Halifax says there was a 72 per cent rise in the number of estates paying IHT in the five years to 2003-04, and the growth continues unabated.

Not surprisingly, IHT is hugely unpopular. According to new research from Friends Provident, three-quarters of people believe the tax is unfair.

"This is no longer a tax on the rich," says Christine Foyster, head of wealth management at the insurer. "Ordinary people are being caught unawares by the IHT trap, mainly because property price gains have so completely outstripped any increases in the IHT threshold."

This threshold - or "nil- rate" band - currently stands at £285,000, above which tax is paid at 40 per cent. Meanwhile, the average house price in the UK has now risen to just under £200,000, according to Land Registry figures. The Halifax says that had the IHT threshold been linked to house price movements, it should by now be £430,000.

Revenue & Customs points out that while the number of estates liable for IHT has risen, it remains relatively low. Its latest figures show just 6 per cent of all estates pay the tax.

"No doubt the argument over keeping, abolishing or reforming IHT will rage on," says Ms Foyster. "I hope it doesn't distract people from the main issue, which is how they can stop this tax hitting their family."

There is a range of ways in which we can mitigate against a hefty tax bill on death, but Paul Wilcox, chairman of WAY, an investment services company, says we tend to leave it far too late. "Our research shows the typical age for IHT planning has traditionally been well after normal retirement. Even the moderately wealthy should start earlier."

Trusts

These have been among the main instruments used to reduce IHT bills, although reforms have blunted their edge. In this year's Finance Act, the rules governing "interest in possession" trusts - the ones most commonly used in IHT planning - were brought into line with discretionary trusts.

In effect, this means that the amount of money you can pay into a trust is now limited to £285,000 - the nil-rate band - if you wish to avoid an IHT charge.

Despite the changes, various types of trust remain useful tax-planning tools.

Gifts

Giving away your wealth is the simplest way of cutting your IHT liability.

You are entitled to hand out up to £3,000 worth of gifts in each tax year IHT-free. In addition, you can make small presents of up to £250 to as many people as you like - as long as they are not the same ones who received the £3,000.

Gifts made out of income - not capital - are exempt from IHT, as are those on the marriage of children (up to £5,000), grandchildren (£2,500) and friends (£1,000). Gifts to charities made during your lifetime - or on death under a will - are also free of the tax.

Potentially exempt transfers

The scope for giving away your assets is in fact even greater, as transfers made more than seven years before your death are excluded from your estate when determining your IHT liability.

When a gift is made, it will be treated as a "potentially exempt transfer" (PET). If you die within seven years of that present, it will be included in your estate - although those gifts passed on three to six years before your death are charged at a reduced rate.

You need to note, however, that you cannot simply hand your home to your children and continue to live in it, in order to avoid paying IHT on its value. Gifts from which you continue to benefit are treated as "gifts with reservation" and are still regarded as part of your estate.

Spouse exemption

Married couples - and those in civil partnerships - can transfer assets between themselves without incurring IHT. This allows couples to use both their nil- rate bands efficiently.

If you and your spouse own your home, make sure you do so as "tenants in common", rather than as "joint tenants". You should then draft your wills to state that each partner leaves their half share to a discretionary will trust. This will allow the surviving partner to remain in the house.

When that person dies, he or she will be leaving just half of the house to their dependants, so any IHT bill will be significantly reduced.