The latest figures from HMRC reveal a concerning trend in inheritance tax (IHT) liabilities, as seen in the tax year 2020 to 2021, where there were 27,000 taxpaying IHT estates—an increase of 4,000 (17%) since the previous year, says Rachael Griffin, tax and financial planning expert at Quilter. 

This rise in IHT tax liabilities, amounting to £5.76bn, represents a significant 16% increase compared to the previous year, making it the largest single-year rise in IHT tax liabilities since 2014 to 2015 when tax liabilities rose by 25% (£840m).

One key driver behind this surge in tax liabilities is the 18% increase in overall UK deaths, partly attributed to the COVID-19 pandemic and escalating property prices, contributing to more individuals ending up with IHT liabilities.

The number of deaths in the UK rose from 612,000 to 722,000 (18%), leading to a knock-on rise in taxable wealth transfers. Additionally, the frozen Nil-Rate Band (NRB) also contributes to the rise in IHT tax liabilities, as it means more and more people end up with an IHT liability.

IHT liabilities are now at their highest level on record, surpassing the previous peak of £5.05 billion in the 2016 to 2017 tax year.

IHT remains widely unpopular, making it a prime candidate for much-needed reform. With IHT thresholds frozen until 2027/28, more and more people are getting caught in the IHT net simply because of property wealth. The impact of soaring inflation, coupled with the cost-of-living crisis, disproportionately affects the younger population. Consequently, there is a growing need to facilitate the smooth transfer of wealth both during one's lifetime and upon the passing of loved ones.

While there was a 16% (£800 million) increase in tax liabilities between the 2019 to 2020 and 2020 to 2021 tax years, the proportion of UK deaths resulting in an Inheritance Tax (IHT) charge decreased slightly by 0.03 percentage points since the tax year 2019 to 2020. This means the proportion has been relatively flat since the tax year 2017 to 2018 - likely as a result of the introduction of the tax-free allowance known as the Residence Nil-Rate Band (RNRB) from that year onwards.

The RNRB is available to those estates that transfer their main UK residence to direct descendants on their death. Although many people find this threshold devilishly difficult to navigate.

There has been much talk of abolishing IHT altogether over the years. Proponents of abolishing IHT laud the move as a move away from taxing people twice on their earnings. The reality is that there is a chance that abolishing IHT could help turbocharge wealth creation and therefore the economy but abolition could also usher in a new even more hated tax - a wealth tax.

Considering how lucrative the tax is, getting rid of it altogether could punch a hole in the country's budget compounding an already bleak economic outlook and the government will need to fill that hole. 

There are some serious flaws in IHT however that need to be ironed out to ensure that the middle classes don't end up paying a higher AETR (Average Effective Tax Rate) than the mega wealthy. According to the statistics the AETR gradually rises as the value of the net estate increases, reaching 13% for estates valued at between £1 million and £1.5 million and further rising to 20% for estates valued between £1.5 million and £2 million.

This ultimately leads to an average AETR of 25% for taxpaying estates valued at between £2 million and £7.5 million in the 2020 to 2021 tax year. Yet, the AETR for the largest taxpaying estates in 2020 to 2021 was lower than for those estates valued at 17% respectively for estates valued at between £7.5 million and £10 million, and above £10 million.

This is simply because these estates often make proportionately greater use of available exemptions and reliefs than those estates that are smaller helping to confirm the saying that IHT is a voluntary tax.

Simplifying aspects of inheritance tax is crucial for effective reform. The residence nil rate band (RNRB) is complex and poorly understood, causing confusion for those navigating inheritance tax. A far simpler approach would be to scrap it and increase the nil-rate band, which could be beneficial for a larger number of estates.

Another good middle ground that not only would help people mitigate inheritance tax but also help more money cascade down generations would be to revise the gifting laws that are currently frozen in time. By updating the annual exemption to reflect current inflation, individuals would be incentivized to make more lifetime gifts, promoting a smoother wealth transfer across generations, which would be very welcome during this cost of living storm.

These new statistics underscore the pressing need for thoughtful reform. While IHT serves as a vital source of revenue and contributes to wealth redistribution, the frozen thresholds and outdated allowances create significant challenges for families and create inequitable differences when it comes to the average effective rate of tax paid by varying estates.

A balanced approach, such as adjusting rates and thresholds or simplifying gifting laws, could offer a pragmatic solution to address the concerns of taxpayers and promote a fairer system of wealth transfer in the UK.

By Rachael Griffin, tax and financial planning expert at Quilter.