Inheritance tax: Expert explains what it is, how it works and how to mitigate it

Currently, the standard inheritance tax rate is 40 per cent. IHT isn’t normally payable if you leave everything to your spouse or civil partner. Most pensions sit outside of your estate for IHT purposes under current rules.

The amount of inheritance tax paid by families has rocketed over the past decade, partly because of rising property prices and frozen inheritance tax thresholds, but also a consequence of many families failing to plan early.

How does the IHT nil-rate band work?

The inheritance tax nil-rate band in the 2024/25 tax year is £325,000. It means that no IHT is payable on the first £325,000 of your estate when you die, regardless of who you leave it to.

Married couples and civil partners can transfer any unused element of their nil-rate band to their living partner when they die. This means a couple has a joint nil rate band of £650,000.

What is the additional IHT allowance?

In April 2017, an additional inheritance tax allowance was introduced called the ‘residence nil-rate band’. To qualify for this allowance, you must pass on your main residence, or the sale proceeds of your former residence, to your children (including adopted, foster or stepchildren) or grandchildren when you die. For the 2024/25 tax year, the maximum residence nil-rate band is up to £175,000, meaning your overall IHT allowance could increase to £500,000. Like the standard nil-rate band, you can transfer any unused portion of your residence nil-rate band to your surviving spouse or civil partner when you die.

The residence nil-rate band is tapered by £1 for every £2 that your estate exceeds £2m. This means that it won’t be available if your estate’s assets exceed £2.35m.

How can inheritance tax be mitigated?

There are a range of measures that, with careful planning, could be used to reduce inheritance tax. Ensure your will is updated, as some older wills hold assets in trust, which could mean you lose out on the nil-rate band or the residence nil-rate band. Many people wait until death to pass on their assets. However, it could prove more tax efficient to gift money while still alive.

Gifts not covered by an exemption are either ‘potentially exempt transfers’, meaning you must survive for at least seven years for them to be tax free, or ‘chargeable lifetime transfers’, which are immediately assessable to IHT.

Pensions could also be a tax-efficient way of passing on money. If you die before age 75, benefits left in a money purchase pension can usually be passed on tax free. After age 75, they will be taxed at the beneficiary’s marginal rate of income tax. It might make sense to use other investments, such as ISAs, to provide a retirement income and retain funds in your pension for as long as possible.

Other potential ways to reduce IHT include setting up trusts, specialist investment vehicles and whole-of-life insurance.

It is important to remember that legislation changes, and so your current plans may no longer meet your objectives. It is therefore important to seek financial advice early to give yourself the best chance of passing on a legacy that suits your circumstances.

Michelle Holgate is divisional director of financial planning for RBC Brewin Dolphin’s Leeds office