This guide explains Inheritance Tax in plain English, breaking down the rules, allowances and legitimate strategies that could help protect your family’s financial future.
You’ve worked hard all your life, focusing on creating wealth to enjoy retirement and to care for your family. Hopefully, you’ve managed to pay off your mortgage, and overall, you’ve spent wisely.
No doubt you’ve paid the required income tax, capital gains tax, stamp duty, VAT, Insurance premium tax (IPT), and are now becoming more aware that the taxman might take a significant chunk of your legacy before the family sees a penny through Inheritance Tax (IHT). It affects thousands across the UK. Yet, many people are unaware of it until it’s too late to plan effectively. However, understanding how IHT works and, more importantly, how to manage it can make a substantial difference to what you leave behind.
This guide explains Inheritance Tax in plain English, breaking down the rules, allowances and legitimate strategies that could help protect your family’s financial future. We’ll show you why getting professional help with legacy planning isn’t just for the wealthy. It’s for anyone who wants to maximise what they pass on to the next generation.
Inheritance Tax basics
IHT is a tax on the estate of someone who has died.
Your estate includes everything you own at the time of death, minus any debts you owe.
Currently, IHT is payable when your estate exceeds £325,000. This threshold is called the nil-rate band. Everything above this amount, after personal and business allowances, is taxed at 40%. So, if your estate is worth £525,000, that’s £200,000 over the allowance, and the IHT bill would be 40%: £80,000.
The executors of your will are responsible for valuing your estate and arranging payment of any IHT due. Be mindful, though, in most cases, IHT must be paid within six months of death, often before probate is granted. This can force bereaved families to take out loans or sell assets quickly, potentially at below-market prices, to settle the IHT bill.
Your beneficiaries don’t pay IHT directly. It comes out of your estate before it is distributed. However, the beneficiaries are the ones who ultimately feel the impact through a reduced inheritance.
Not everyone pays IHT. Married couples and civil partners can pass assets between each other tax-free and various allowances and exemptions (£3,000 a year to anyone, which can also be carried forward from the previous year), and a £250 small gift exemption can help reduce the bill legitimately.
But with property prices rising and the current nil-rate band frozen until 2030, more families find themselves caught in the IHT net each year.
What counts towards your estate?
Calculating your estate’s value for IHT planning purposes means adding up everything you own.
The total might surprise you.
Your home usually represents your most significant asset, and its current market value counts towards your estate, not what you originally paid for it. With UK property prices having risen significantly over the past twenty years, ordinary family homes now push many estates over the IHT threshold.
All your savings, investments, shares and premium bonds count, too. That includes ISAs. While they are tax-free during your lifetime, they lose this protection upon death.
Your personal possessions (chattels) can also add up quickly, and these also need to be included: your car, jewellery, art, furniture and collections all have value. Your business interests also need to be accounted for, and whilst Business Property Relief (BPR) can reduce the liability for certain types of qualifying business, such as unquoted businesses and business interests, this relief reduces to 50% for certain shares and assets used in a business.
If you haven’t written your life insurance policies in trust, the payouts form part of your estate liable for IHT.
And any gifts you’ve made in the seven years before death might be added back into your estate calculation, potentially triggering an unexpected IHT bill after taper relief has been applied.
Key allowances and exemptions
Various allowances and exemptions can significantly reduce your IHT liability when used effectively.
Your nil-rate band of £325,000 is just the starting point. If you’re leaving your family home to your descendants (such as children, grandchildren or stepchildren), you might qualify for an additional residence nil-rate band (RNRB) of up to £175,000. This means a single person could potentially pass on £500,000 tax-free. A previous home of higher value (before downsizing) could make the most of this allowance.
Married couples and civil partners also enjoy a powerful advantage. Not only can you leave everything to each other IHT-free, but any unused nil-rate band transfers to the surviving spouse. This potentially allows couples to leave up to £1m tax-free to their descendants.
There are also several annual exemptions you can use to reduce your IHT liabilities during your lifetime. You can gift up to £3,000 each tax year immediately free from IHT, carrying forward one year’s unused allowance. Small gifts of up to £250 per person don’t count towards this limit. Parents can gift £5,000 to children getting married, while grandparents can gift £2,500.
Charitable donations can reduce your IHT liability in two ways. If you leave 10% or more of your net estate to charity, the IHT rate on the remainder will reduce from 40% to 36%. Plus, the charitable gifts themselves are exempt.
Pensions currently sit outside your estate for IHT purposes, making them incredibly tax-efficient for passing wealth between generations. However, the rules are set to change in 2027, with the Labour Government pressing ahead with plans to include most unused pension funds in the value of a person’s estate for IHT purposes. So, getting professional advice about how these upcoming changes may affect you and your loved ones is essential.
The ‘seven-year rule’ explained
The ‘seven-year rule’ governs how lifetime gifts are treated for IHT purposes, making timing crucial for tax planning.
When you make a gift, it’s either immediately exempt (using your annual allowances) or potentially exempt (a PET). PETs become completely IHT-free if you survive seven years after making them.
If you die within seven years, your PETs get added back to your estate. However, the taper relief reduces the tax rate on gifts made between three and seven years before your death. The relief starts at 20% (year 3-4) and increases to 80% (year 6-7).
Keeping detailed records of everything you gift is essential. Include dates, amounts, recipients and the occasion. Without proper documentation, HMRC might challenge your exemptions or apply full IHT rates. The seven-year clock resets with each gift, so spreading large gifts over time might be more tax-efficient than making them all at once.
Be mindful of ‘Chargeable Lifetime Transfers’ (CLTs), which are gifts in excess of your allowances, such as payments into a discretionary trust, and are potentially chargeable at the time of the gift if you’ve exceeded these allowances.
CLTs carry a 20% lifetime charge on the amount over the nil rate band if paid by the donor, or 25% if paid by the recipient. They are paid immediately on the gift if the value of CLTs in the past seven years, including the new one, exceeds the nil rate band.
If the donor dies within seven years of making the transfer, the full rate of 40% IHT is payable, with any lifetime tax already paid credited against the IHT due. Taper relief might apply to reduce the tax, depending on how many years pass between the gift and death.
An example of a CLT would be an individual placing money (or other property) in a trust that exceeds their allowances, or making a ‘gift with reservation of benefit’ by giving something away but retaining its use, such as a house or painting remaining in the donor’s home. In this instance, the gift be treated as a PET, which, as explained earlier, would be taxable upon death within seven years.
How can Heathcote Financial Planning help?
Inheritance Tax planning isn’t about avoiding your responsibilities. It’s about using legitimate allowances and strategies to preserve more of your hard-earned wealth for the loved ones you leave behind. It involves navigating complex legislation, understanding how different taxes interact, and making decisions that could affect your family for generations.
Getting it wrong can cost thousands in unnecessary tax or, worse, leave you without enough to live on. So, the sooner you start planning, the more options you’ll have and the more you can potentially save. Your retirement income needs, long-term care considerations and family circumstances can all influence the best approach for you.
As chartered financial planners, we bring insight and expertise to your IHT planning. We’ll analyse your complete financial picture, not just your IHT position in isolation. Then, we’ll create a personalised strategy using the most appropriate combination of allowances, exemptions and planning tools. This might involve restructuring how you hold assets, establishing trusts or reorganising your investment portfolio. We’ll ensure any IHT planning complements your other financial goals rather than compromising them.
Tax legislation changes regularly. The strategies that work today might not work tomorrow. So, we also provide ongoing reviews, adjusting your plan as rules change and your circumstances evolve. When the Government announces changes, we’ll explain what they mean for you and adapt your strategy accordingly.
Most importantly, we’ll give you confidence that you’re doing everything possible to protect your family’s financial future. You’ll have peace of mind knowing your loved ones won’t face unnecessary tax bills or financial stress during an already difficult time. Book a consultation to discover how we can help you secure your financial legacy.
Disclaimer
This article is intended for educational purposes only and does not constitute personal financial or legal advice. Inheritance Tax (IHT) planning can be complex, and the strategies discussed may not be suitable for everyone. Tax treatment depends on individual circumstances and current legislation, which may be subject to change in the future.
You should not take any action based on the information in this article without first seeking advice from a qualified financial planner or legal adviser. While we endeavour to ensure accuracy, Heathcote Financial Planning accepts no liability for any errors or omissions.
Heathcote Financial Planning is authorised and regulated by the Financial Conduct Authority.
Company registration
Heathcote Financial Planning is a trading style of The Mortgage and Protection Partnership Ltd, authorised and regulated by the Financial Conduct Authority (No: 612049). Registered address: Olympus House, Olympus Park, Quedgeley GL2 4NF. Company No: 08734287.