Inheritance tax (IHT) can be one of the most unexpected financial burdens your loved ones face after your passing. While it’s often viewed as a tax reserved for the wealthiest individuals, many families are caught off guard when their estates are subject to IHT, potentially diminishing the legacy they hoped to pass on.

Understanding inheritance tax, its potential impact, and how to legally minimise it is key to protecting your wealth and ensuring your beneficiaries receive what you intended. In this article, we’ll explain how the inheritance tax trap works and provide practical strategies to safeguard your estate.

What is Inheritance Tax (IHT)?

Inheritance tax is a tax levied on the estate of someone who has passed away. It’s applied to the value of the estate that exceeds a certain threshold, and can affect assets such as property, money, investments, and possessions.

In the UK, the standard IHT rate is 40% on estates valued over the nil rate band (NRB), which is £325,000. This means that if your estate is worth more than this amount, your beneficiaries may have to pay 40% tax on the portion of the estate that exceeds £325,000.

For example, if your estate is valued at £500,000, your beneficiaries could be taxed on £175,000 (i.e., the amount above £325,000), which would amount to £70,000 in inheritance tax.

The Inheritance Tax Trap: Why It Catches Many Families Off Guard

The inheritance tax trap is that many families, especially those who are middle-income or those who own property, don’t realise their estate may be liable for IHT until it’s too late. This is often because they focus on the value of their savings and investments without accounting for the value of their home, which can push their estate value over the threshold.

For instance, a family home may be worth several hundred thousand pounds, but the owner’s other assets—such as savings, pensions, or life insurance policies—can push the total estate value beyond the nil rate band, triggering a hefty inheritance tax bill.

While the threshold for IHT remains at £325,000, there are additional allowances and exemptions that can help mitigate this tax burden. However, without proper planning, many families end up facing unexpected tax liabilities, leaving little for their loved ones.

How to Protect Your Wealth from Inheritance Tax

Fortunately, there are several strategies you can employ to reduce the potential impact of inheritance tax on your estate. Here are some key methods to consider:

1. Use the Residence Nil Rate Band (RNRB)

Introduced in 2017, the residence nil rate band (RNRB) offers an additional tax-free allowance for those passing on their family home to direct descendants (children or grandchildren).

In the 2024/2025 tax year, the RNRB is set at £175,000, in addition to the £325,000 NRB. This means if you pass on your home to a child or grandchild, the threshold before IHT kicks in could be up to £500,000 (£325,000 + £175,000).

It’s important to note that this exemption applies only to homes passed to direct descendants and is subject to certain conditions. Planning ahead and ensuring your estate meets these criteria can make a significant difference.

2. Make Lifetime Gifts

One of the most effective ways to reduce the value of your estate for IHT purposes is by gifting assets during your lifetime. There are several allowances for gifts that can be made without incurring IHT:

• Annual gift allowance: You can gift up to £3,000 per year without any tax implications. If you haven’t used this in the previous tax year, you can carry it forward to make a total gift of £6,000.
• Small gifts exemption: Gifts of up to £250 per person per year are exempt from IHT, as long as the recipient hasn’t already benefited from other gifts made during the same year.
• Gifts to charity: Donations made to qualifying charities are exempt from IHT and can even reduce the rate of IHT on the rest of your estate if you leave 10% or more to charity.

These strategies not only reduce the value of your estate but also help ensure your wealth is passed on to loved ones while you’re still alive.

3. Use Trusts to Protect Assets

A trust is a legal arrangement where you transfer ownership of your assets to a trustee, who manages those assets for the benefit of the beneficiaries. By putting assets into a trust, you may be able to reduce your estate’s value for IHT purposes, as the assets are no longer considered part of your estate.

Some popular trust options include:

• Bare trusts, where the beneficiary has the right to access the assets at any time.
• Discretionary trusts, where the trustee has discretion over when and how to distribute the assets.

Trusts can be complex, so it’s advisable to seek professional advice to ensure the trust is set up correctly and to avoid potential pitfalls.

4. Review Your Will Regularly

It’s essential to review your will regularly, especially as your financial situation or family dynamics change. A will ensures your assets are distributed according to your wishes, and with the right planning, it can also help reduce inheritance tax.

For example, your will can specify the use of a trust to protect your estate from IHT, or it can ensure that the residence nil rate band is utilised effectively. Keeping your will up to date helps avoid costly mistakes that could lead to unnecessary tax liabilities.

5. Consider Life Insurance

Taking out a life insurance policy specifically designed to cover inheritance tax liabilities can provide peace of mind and ensure that your beneficiaries won’t have to sell assets to pay the tax bill.

Life insurance can be set up in a trust, so the proceeds go directly to your beneficiaries, bypassing your estate and reducing the amount subject to IHT. This can be a useful strategy, particularly for larger estates.

The inheritance tax trap can be avoided with careful planning and strategic action. By understanding how IHT works and implementing strategies such as lifetime gifting, using trusts, and reviewing your will, you can protect your wealth and ensure your loved ones receive the legacy you intend for them.

Need help with inheritance tax planning?

Speak to an estate planning expert to ensure your wealth is protected for future generations.

Taking the time now to make informed decisions can save your estate from unnecessary tax burdens, giving you and your family the financial security you deserve.

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