Inheritance Tax (IHT) can significantly reduce the amount of wealth you pass on to your loved ones. However, with smart planning, you can legally minimise or even avoid paying IHT. This guide explains how inheritance tax works and the best strategies to ensure more of your estate goes to your family.
1. What is inheritance tax?
Inheritance Tax (IHT) is a tax charged on the estate (property, money, and possessions) of someone who has died. The standard IHT rate is 40% on anything above the tax-free threshold.
What is the inheritance tax threshold?
- The nil-rate band (NRB) is £325,000, meaning no tax is paid on estates valued below this amount.
- The residence nil-rate band (RNRB) allows an additional £175,000 tax-free allowance if passing a home to direct descendants (children or grandchildren).
- This means a married couple can pass on up to £1 million tax-free.
If the estate is left to a spouse, civil partner, or charity, no IHT is due.
For official government guidance on inheritance tax, visit HMRC’s Inheritance Tax overview.
For more on tax-efficient retirement planning, see How to maximise your retirement income.
2. How to legally reduce inheritance tax
1. Gifting assets while alive
One of the most effective ways to avoid IHT is by gifting money or assets before death. However, rules apply:
- You can give away £3,000 per year tax-free (the annual exemption).
- Small gifts up to £250 per person per year are also tax-free.
- Wedding gifts of £5,000 to children, £2,500 to grandchildren, and £1,000 to others are exempt.
- Gifts made more than seven years before death are IHT-free under the seven-year rule.
For full details on gifting exemptions, visit HMRC’s guide on gifts and exemptions.
2. Using trusts to protect your wealth
Placing assets in a trust removes them from your estate, reducing IHT liability. Popular options include:
- Bare trusts – Assets go directly to beneficiaries but are taxed as part of their income.
- Discretionary trusts – Provide flexibility in distributing wealth while keeping it out of your estate.
- Interest in possession trusts – Allow you to earn income from an asset while protecting it for future generations.
For more details on how trusts affect inheritance tax, see HMRC’s guide on trusts and taxes.
3. Leaving money to charity
Donating to charity reduces your taxable estate, and if you leave at least 10% of your estate to charity, your IHT rate is reduced from 40% to 36%.
For example, if your estate is worth £600,000, donating £60,000 to charity would lower the IHT bill on the remaining taxable amount.
4. Making use of pensions
Pensions are not subject to inheritance tax if left to beneficiaries. Keeping money in a defined contribution pension (SIPP or workplace pension) rather than withdrawing it all can be an effective way to pass on wealth tax-free.
For more on tax-efficient pensions, read What to do with your pension pot when you retire.
5. Life insurance policies held in trust
Taking out a life insurance policy and placing it in trust means the payout is not included in your estate. This ensures beneficiaries receive the full amount without paying 40% tax.
6. Passing on your family home wisely
Your main residence can benefit from the residence nil-rate band if left to children or grandchildren. To avoid IHT issues:
- Ensure the property passes directly to heirs.
- Consider downsizing, as unused RNRB can still apply to other assets.
For advice on downsizing, read Is downsizing your home a good idea for retirement?.
3. Common mistakes to avoid
1. Not planning gifts properly
If you die within seven years of giving a large gift, it may still be subject to IHT. Use the taper relief system to reduce tax on gifts made between three and seven years before death.
2. Not updating your will
A clear and legally binding will ensures assets are distributed as intended and prevents unexpected tax liabilities.
3. Keeping too much money in taxable accounts
Using ISAs and pensions instead of standard savings accounts can reduce inheritance tax liability.
For tax-free savings, read A guide to ISAs for UK retirees.
Conclusion: Plan early to protect your wealth
With careful planning, inheritance tax can be significantly reduced or even avoided. By gifting assets, using trusts, maximising pension benefits, and leveraging tax exemptions, you can ensure more of your estate is passed to loved ones.
For more financial planning tips, explore other guides on Retirement Pasta.
