Donating money to charity can be a very tax-effective way to reduce the amount of inheritance tax payable, but is it worth it? We go through some examples to help you decide whether this strategy could work for you.
Giving money to charity to save inheritance tax
One way to reduce the amount that the taxman takes from an estate in inheritance tax is to make a donation to charity. This can be particularly tax effective. The donation is taken off your estate before inheritance tax is calculated, and if the donation is large enough – at least 10% of your net estate – the rate at which inheritance tax is levied on the remainder of the estate is reduced.
Making smaller donations
Even if the donation is less than 10% of the estate, it will be effective in reducing the amount of inheritance tax paid. This is because the donation is deducted from the net estate before working out the inheritance tax payable.
An individual dies leaving a net estate (after allowing for the nil rate band and residence nil rate band) of £400,000. The estate is left to his children. Inheritance tax of 40% of the net estate is payable – an inheritance tax bill of £160,000. After inheritance tax, the children receive £240,000 in total.
Assume instead that the individual had left £20,000 to charity and the remaining £380,000 to his children. The inheritance tax bill will now be 40% of (£400,000 – £20,000), i.e. £152,000.
Leaving £20,000 to charity saves £8,000 in inheritance tax. After inheritance tax, the children receive £228,000 and the charity £20,000 – a total of £248,000. The £20,000 gift to charity effectively costs the children £12,000.
Donations of at least 10% of the net estate
To encourage charitable giving on death, the rate of inheritance tax is reduced by 10% — from 40% to 36% — where at least 10% of the net estate is left to charity. The effect of this can be
illustrated by the following example.
An individual dies leaving a net estate of £1 million, split equally between his four children. Inheritance tax payable on the estate is £400,000 (40% of £1 million), leaving £600,000 after tax (£150,000 per child).
If instead, the individual had left 10% of his estate to charity – equal to £100,000, the amount on which inheritance tax is payable is reduced to £900,000 and the rate of inheritance tax is reduced to 36%. The inheritance tax payable on the estate is now £324,000 – a reduction of £76,000. The children receive £576,000 and the charity receives £100,000 – a total of £676,000.
The gift of £100,000 to the charity effectively costs the children £24,000 as a result of the inheritance tax savings.
Is it worth it?
It depends on your outlook. If the aim is to reduce the amount that the taxman gets or make a tax-efficient gift to charity, the answer is yes. However, if the beneficiaries want to maximise the amount that they get from the estate, the answer is no. In each case, they are worse off by making the charitable donation than by taking the inheritance tax hit. While it may be preferable for money to go to charity rather than to HMRC, some of the charitable gift is coming out of their pocket.
Charitable giving can reduce the inheritance tax payable, but at a cost.
Partner note: IHTA 1984, s. 23, Sch. 1A.