The £1 million inheritance tax-free allowance figure is one of those numbers that has taken on a life of its own. Most people know about it, but very few have checked whether it applies to them.
At first glance, it seems straightforward. A couple has two nil-rate bands – also known as inheritance tax-free thresholds – at £325,000 each and two main residence nil rate bands at £175,000 each. Add the allowances together and you get £1 million you can pass on free of inheritance tax, which is otherwise charged at up to 40%.
But in reality, it is more complicated.
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For example, if you’re married or in a civil partnership, any unused inheritance tax-free threshold can be added to your partner's threshold when you die. This tax perk does not apply to unmarried couples.
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Sue Allen, chartered financial planner at Chester Rose Financial Planning, warns. “Care needs to be taken to ensure you qualify or know where you stand,” she says.
The issue usually lies with the £175,000 residence nil-rate band, which you could get if you give your home to your children or grandchildren. This extra allowance is often treated as part of the standard allowance. But it isn’t – and certain rules mean you may not get it.
When does the £1 million inheritance tax-free allowance not apply?
In practice, there are a few common scenarios where the main residence nil rate band is assumed to apply but doesn’t.
1. Couples without children
Couples without children are a straightforward example of where the £1 million inheritance tax-free allowance doesn’t apply.
“It is common for them to assume they are comfortably within the £1 million threshold, only to find that, without direct descendants, the main residence nil rate band doesn’t apply to them,” said Allen.
“At that point, the IHT allowance drops to £650,000 between them, which can come as quite a shock.”
2. Estates worth more than £2 million
The £2 million inheritance tax threshold acts as a tapering point for the residence nil-rate band. If your estate – total assets minus debts – is worth more than £2 million, the residence nil-rate band is reduced by £1 for every £2 that the estate exceeds this threshold.
If an estate's net value exceeds £2.35 million, the residence nil rate band is completely lost for a single individual. For a surviving spouse, the threshold for complete loss is £2.7 million.
“There is a growing number of people, particularly in London and the Southeast, who find themselves over the £2 million threshold without really thinking of themselves as having large estates. A property and a reasonable level of investments can get you there,” said Allen.
“We often find that, as a result, these clients don’t qualify at all for the main residence nil-rate band.”
Inheritance tax on pensions is due to change in April 2027, with most pensions being treated as part of the estate by HMRC for IHT purposes from then. This will increase the value of estates, potentially pushing them over the £2 million threshold when the residence nil rate band starts to taper.
3. Downsizers
Later-life decisions can create further complications when it comes to inheritance tax thresholds. Downsizing, for example.
There are rules that allow you to preserve a percentage of the main residence nil rate band when you sell a property – known as the downsizing addition or downsizing relief. However, these rules are not straightforward and require careful planning.
The amount of the downsizing addition will usually be the same as the residence nil rate band lost when the former home is no longer in the estate. Again, the amount of the preserved main residence nil rate band needs to be left to direct descendants to qualify.
It will also depend on the value of the other assets left to direct descendants. The downsizing addition cannot be more than the maximum amount of residence nil rate band available if the sale or downsizing had not happened.
The estate’s personal representative must make a claim for the downsizing addition within two years of the end of the month that the person dies. HMRC can extend this time limit in some circumstances.
You do not have to tell HMRC when the downsizing move, sale or gift of the former home happens. The estate’s personal representative makes a claim for residence nil rate band and any downsizing addition when filling in the inheritance tax returns.
You should keep the details of the move, gift or sale so that the estate’s personal representative can get that information when they make the claim.
You can only take one move, sale or other disposal of a former home into account for the downsizing addition. If the person that died downsized more than once, or sold or gave away more than one home between 8 July 2015 and the date they died, the estate’s personal representative can choose which to use to calculate the downsizing addition.
4. Blended families
Blended families are another area where things don’t always align when it comes to inheritances. They are increasingly common, but the inheritance rules haven’t kept pace. This can often lead to disputes over inheritances.
“It’s easy for assets to be passed in a way that makes perfect sense from a family perspective but doesn’t meet the technical requirements for the main residence nil-rate band,” said Allen.
For residence nil rate band purposes the direct descendant is:
- a child, grandchild or other lineal descendant
- a spouse or civil partner of a lineal descendant (including their widow, widower or surviving civil partner)
This also includes:
- a child who is, or was at any time, their step-child
- their adopted child
- a child fostered at any time by them
- a child where they’re appointed as a guardian or special guardian when the child is under 18
The person who inherits the home does not have to be under 18. But a person’s step-child is only someone whose parent is, or was, the spouse or civil partner of that person – cohabiting doesn’t count.
Direct descendants also do not include nephews, nieces, siblings and other relatives.
How to avoid the £1 million inheritance tax trap
The key thing to do is forget the £1 million inheritance tax-free threshold – unless it actually applies to your specific situation. If you’re able to, using gift allowances and giving gifts early on could reduce a potential inheritance tax bill, as inheritance tax is not charged on gifts made more than seven years before death.
“Plan around the actual position,” said Allen, from Chester Rose. “In many cases, that means starting to gift earlier rather than later, as the seven-year rule is only useful if there is enough time for it to work.”
Regular gifting out of surplus income is also often overlooked, despite being one of the more practical options available.
“However, careful record-keeping and a clear understanding of the rules are essential, as not all assumed income qualifies. It is also important to have a cash flow plan in place that identifies how much you can afford to gift and when. You do not want to leave yourself short in later life,” said Allen.
Wills might need to be revisited to ensure the structure doesn’t prevent the claiming of the main residence nil rate band, or that planning can be undertaken after death to ensure this can be claimed. “This is particularly important when trusts are incorporated into wills,” said Allen.
For those close to the £2 million threshold, even small adjustments can help preserve part of the main residence nil-rate band. Without such planning, it can disappear entirely.
“The £1 million figure isn’t wrong, but it is conditional,” Allen said. “The difficulty is that most people don’t realise how conditional it is until they look more closely at their own situation. By then, the number they have relied on for years isn’t quite right.”
Inheritance tax planning can be complicated and is highly individual to specific circumstances. It’s always a good idea to get specialist legal and financial advice before acting.
