Inheritance tax is sometimes called a voluntary tax because with proper planning many people can legitimately reduce or eliminate the amount their estate pays. But understanding how it works is the essential first step.
- The basics of inheritance tax
- Gifts and the seven year rule
- Pensions and inheritance tax
The basics of inheritance tax
Inheritance tax is charged at 40% on the value of your estate above the nil rate band threshold of £325,000. Everything below this threshold passes to beneficiaries tax-free.
There is an additional residence nil rate band of £175,000 which applies when you pass your main home to direct descendants such as children or grandchildren. This means a single person can potentially pass up to £500,000 free of inheritance tax, and a married couple up to £1 million.
Gifts and the seven year rule
One of the most effective ways to reduce your inheritance tax liability is to make gifts during your lifetime. Gifts made more than seven years before death are completely exempt from inheritance tax. Gifts made in the three years before death are taxed at the full 40% rate, with tapering relief applying between three and seven years.
Each person has an annual gift exemption of £3,000 per tax year, which can be given away completely free of inheritance tax regardless of when you die. Unused allowance from the previous year can be carried forward once.
Spouse exemption
Assets passed between married couples and civil partners are completely exempt from inheritance tax, regardless of value. This means you can leave your entire estate to your spouse without any inheritance tax liability, with the tax only becoming relevant when the surviving spouse passes away.
Pensions and inheritance tax
Pension funds are currently outside your estate for inheritance tax purposes, making them an extremely tax-efficient way to pass wealth to the next generation. However, this is subject to change following government proposals to bring unused pension funds within estates from 2027.
Bottom line
Inheritance tax planning is most effective when started well in advance. Review your estate regularly, make use of annual gift exemptions, ensure your will is up to date, and consider taking specialist advice from an estate planning professional if your estate is above or approaching the threshold.