How does inheritance tax work?

Many are daunted when it comes to managing a potential inheritance tax (IHT) liability, mostly because there is some general misunderstanding of how it works. Inheritance tax is essentially a transfer tax between individuals, trusts and family members. All transfers in excess of the inheritance tax threshold are potentially subject to tax - even if made prior to death.

In a world where we seemingly pay tax on everything, inheritance tax can often be avoided with some expert financial planning. Intergenerational wealth – or rather the way in which we pass our assets through the family line – has never been more important. Ultimately, it’s ensuring your loved ones receive their inheritance in the most tax-efficient way possible.

Who pays inheritance tax?

Under current rules (2024/25 tax year) each of us is given a nil-rate band for IHT which is currently £325,000. This means if the total value of your estate is less than £325,000 you won’t be liable to pay any inheritance tax. If you give away your home to your children (including adopted, fostered or stepchildren) or grandchildren, this threshold can increase to £500,000.

If you are married or in a civil partnership, your estate will pass inheritance tax exempt to your spouse on your death if this is your wish. If you have left legacies to someone other than your spouse in your will, this will utilise your nil rate band (NRB). Your spouse will inherit all or any remaining NRB, depending on the provisions of your will. This means that the combined threshold for a couple can be as much as £1m.

What’s the inheritance tax rate?

The standard inheritance tax rate is 40% and is only charged on the part of your estate deemed to be above the threshold.

Transfers between spouses on death are free of IHT, therefore estates may only pay the tax after the second person has passed away, depending on the provisions of their will. This additional threshold on property is known as the Residence Nil Rate Band. However, this additional band is reduced for estates valued at more than £2m. This reduction is applied at a rate of £1 for every £2 over the £2m limit. So, for estates over £2.35m, the additional residential nil-rate band is lost.

Can making gifts help reduce an IHT liability?

Gifting money to others, perhaps children or grandchildren to help them out financially, can potentially reduce an IHT bill. However, great care must be taken. Being over-generous could leave you with too little to live on and it is important to distinguish between different types of gifts.

Exempt gifts include an annual £3,000, which can be given to one person or spread between a number of people, plus £250 a year to as many people as you like. In addition, you can make one off marriage gifts of up to £5,000 to children and £2,500 to grandchildren.

It is also possible to make regular gifts from your income as long as they are made regularly, are from your ‘surplus’ income and do not cause you to use capital to maintain your usual standard of living.

Finally, donations to charity either during your lifetime or in your will are generally exempt.

Could you pay inheritance tax on gifts?

It’s important to note that any gifts that add up to more than the nil-rate band of £325,000 are chargeable for inheritance tax. While outright gifts to individuals and certain trusts have the potential to be exempt from IHT with a Potentially Exempt Transfer (PET), if an individual dies within seven years of the gift or transfer, it becomes chargeable for IHT purposes and will be taken into account in the individual’s IHT calculation on death.

Through careful planning it is possible to gift sums at an opportune time, or at various stages, to make use of the nil-rate band through an appropriate means, for instance using a discretionary trust to retain control over who benefits from the money and when.

There are also other types of trusts that allow you to receive some income or capital. This is a complex area where Charles Stanley has specialist expertise, and we can tailor a solution to specific needs.

Read more: How can you reduce your inheritance tax bill?

How can AIM Shares and Business Property Relief help?

If held for at least two years, certain assets may qualify for 100% “Business Property Relief” from IHT. These include shares in qualifying shares listed on the Alternative Investment Market (AIM).

AIM shares are generally high risk because businesses are at an early stage and are not subject to the requirements of a full London Stock Exchange listing. Business property relief is not available where a business (including an AIM-listed one) deals mainly in land or buildings or is involved in making or holding investments.

Read more: Are ISAs subject to inheritance tax?

Are pension funds free from IHT?

Pension funds such as personal pensions, including SIPPs, are generally outside a person’s estate for IHT purposes under current rules. Therefore, there is potential for pension assets to pass through generations of a family with little tax to be paid. The taxation of pensions depends on individual circumstances and may be subject to change in the future.

If you’ve got more questions around IHT tax, use our handy inheritance tax calculator for an estimate of how much you could pay.