Understanding Inheritance Tax

What is inheritance tax?

Inheritance tax (IHT) is a tax on the estate of someone who has died. It's charged at 40% on the value of the estate above the tax-free threshold. In practice, only about 4–5% of estates pay IHT each year — but if yours is one of them, the bill can be substantial.

IHT is paid by the estate before anything is distributed to beneficiaries. Your executors are responsible for calculating and paying the tax.

The nil-rate band: £325,000

Everyone has a tax-free allowance called the nil-rate band, currently set at £325,000. This means the first £325,000 of your estate is not subject to IHT.

This threshold has been frozen at £325,000 since 2009, despite rising property values. As a result, more families are being caught by IHT than ever before.

The residence nil-rate band: £175,000

If you leave your home to a direct descendant (child, grandchild, or their spouse), you get an additional allowance of up to £175,000 called the residence nil-rate band (RNRB).

Combined with the standard nil-rate band, this means an individual can potentially pass on up to £500,000 tax-free.

However, the RNRB is tapered for estates worth more than £2 million, reducing by £1 for every £2 above that figure.

Married couples and civil partners

One of the most important IHT rules: everything you leave to your spouse or civil partner is exempt from IHT, regardless of value. This is called the spouse exemption.

What's more, any unused nil-rate band can be transferred to the surviving spouse. This means a couple can potentially pass on up to £1 million tax-free:

• £325,000 + £325,000 (combined nil-rate bands) = £650,000
• £175,000 + £175,000 (combined residence nil-rate bands) = £350,000
• Total: £1,000,000

What's included in your estate?

Your estate for IHT purposes includes:

• Your home and any other property
• Savings, investments, and bank accounts
• Personal possessions (jewellery, vehicles, art)
• Life insurance policies not held in trust
• Gifts made within seven years of your death (see below)
• Your share of jointly owned assets

Some assets are harder to value, such as business interests, agricultural land, and overseas property. Professional valuations may be needed.

How to reduce your inheritance tax bill

There are several legitimate ways to reduce IHT:

Leave gifts to charity

If you leave at least 10% of your net estate to qualifying charities, the IHT rate drops from 40% to 36%. This can actually mean your beneficiaries receive more overall.

Make gifts during your lifetime

You can give away £3,000 per year without it counting towards IHT (the annual exemption). Small gifts of up to £250 per person are also exempt, as are wedding gifts within certain limits.

Larger gifts are known as potentially exempt transfers (PETs). If you survive seven years after making the gift, it's completely exempt from IHT. If you die within seven years, the gift may be partially or fully taxable.

Use trusts

Certain types of trust can help reduce IHT, though the rules are complex and professional advice is essential.

Business and agricultural relief

If you own a qualifying business or agricultural property, you may be entitled to relief of 50% or 100%, significantly reducing the IHT on those assets.

Life insurance in trust

If you hold a life insurance policy in trust, the payout goes directly to the beneficiaries outside your estate, meaning it's not subject to IHT. This is one of the simplest and most effective planning tools available.

When is IHT due?

IHT must be paid within six months of the end of the month in which the person died. If it's paid late, interest is charged.

In practice, executors often need to pay IHT before they can access the estate's assets (since probate is usually needed to access bank accounts). This can create a cash-flow problem, which is another reason life insurance in trust can be so valuable.

Getting professional advice

IHT planning can save your family a significant amount of money, but the rules are complex and change regularly. While your will is the foundation of any estate plan, it's worth considering professional tax advice if your estate is likely to exceed the nil-rate band.

A well-drafted will is the first step to making sure your family keeps as much of your estate as possible.