What is inheritance tax (IHT)?

More families are falling into the inheritance tax (IHT) trap, and the government is raising record sums from it – but what is IHT?

IHT is charged on the total value of your assets above a certain threshold when you die. The government raked in a record-breaking £7.5 billion in the 2023/24 tax year in IHT, as frozen IHT thresholds mean more estates are paying this so-called ‘death tax’ due to high property prices and rising asset values.

The taxman took £4.3 billion from IHT payments for April to September – the first six months of this tax year – 10% higher than the same period a year ago, according to the latest data from HM Revenue & Customs.

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Meanwhile, Rachel Reeves's maiden Budget last month unveiled changes to the inheritance tax regime, most notably subjecting pension pots to the tax. She also announced that the £325,000 tax-free allowance (known as the "nil-rate band") would be frozen until 2030.

But what exactly is inheritance tax, who pays it, and how can you reduce how much goes to the taxman?

What is inheritance tax (IHT)?

IHT is a tax on your estate when you die. It’s payable on your property, possessions, savings, investments and business assets. It may also be due on gifts made within seven years before death.

IHT is charged at 40%, but only on the value of your estate above a certain threshold, known as the nil-rate band. So if your estate is £100,000 above the IHT threshold, then this tax is payable on this extra amount, not the total value of your estate.

However, the amount of IHT you pay isn’t necessarily as simple as it sounds. It’s important to understand the IHT thresholds, and how to reduce your liability to this tax.

What are the IHT thresholds? 

The IHT threshold is currently set at £325,000 per person. If the value of your estate exceeds this amount, the excess may be taxed at 40%.

However, you can leave any amount tax-free to your spouse or civil partner, and you will get a bigger allowance if you leave your home to a direct descendant like a child or grandchild.

For example, if an estate is valued at £500,000 and the nil-rate band is £325,000, IHT could be charged at 40% on the remaining £175,000. This leaves an IHT bill of £70,000. But if you left your estate to your spouse or civil partner, they wouldn’t need to pay this bill.

If you're married or in a civil partnership, you can also pass any unused nil-rate band to your partner when you die, potentially doubling your combined IHT threshold to £650,000.

If you leave your home to your children or grandchildren, you can also use the residence nil-rate band. This adds an extra £175,000 to your IHT threshold, increasing it to £500,000.

This means that the combined IHT thresholds for a married couple leaving their main residence to their children or grandchildren could be as high as £1 million, on the second death.

Are pensions subject to IHT?

Pension pots are not currently liable for inheritance tax. They typically fall outside the estate when someone dies, so they can be passed to beneficiaries free of IHT.

However, the chancellor announced in her Budget that the government will bring unused pension funds and death benefits payable from a pension into a person’s estate for IHT purposes from 6 April 2027.

Tom Stevenson, investment director at Fidelity International, says the announcement was “largely expected” as the inheritance tax exemption for pension pots “is something of an anomaly”.

Some experts have called the move a "blow for savers", especially because if the pension saver dies after age 75, the beneficiaries could face a double tax of IHT plus income tax on withdrawals.

Who pays IHT?

In most cases, the executor of the will pays IHT to HMRC. If there isn’t a will in place when someone dies, whoever is appointed as the administrator of the estate will make the payment.

IHT is usually paid from the estate, or raised from the sale of estate assets. Rules state that it must be paid by the end of the sixth month after the person’s death. If the tax isn’t paid within this timeframe, HMRC will start charging interest.

Beneficiaries of the estate will usually receive their inheritance only after the IHT has been paid and any other debts or expenses have been settled. However, in some cases, beneficiaries may agree to pay IHT themselves if the estate lacks sufficient funds to cover the tax liability.

According to investment platform AJ Bell, around one in 25 deaths in the UK results in an IHT liability. But the number of estates liable for this tax is expected to increase in the coming years, as the nil-rate band has been frozen until 2030, and pension pots become subject to the tax.

How to reduce IHT

There are several ways to reduce your IHT bill. These include:

Write a will: Making a will ensures your assets are distributed to who you wish when you’re gone, and can help to reduce any IHT liability. You can ensure you make full use of your IHT allowances and reliefs. Without a will, your estate is subject to intestacy rules, which means your loved ones may not inherit what you want, and the taxman may get more than necessary.

Donate to charity: If you leave at least 10% of your estate to charity in your will, you could reduce your IHT rate. You’ll get a 4% discount, reducing it from 40% to 36%. The government IHT calculator will help you to work out if your estate qualifies for the lower rate.

Leave money in your pension: Your retirement pot is usually free of IHT, and you can choose who you wish to inherit this money when you die. However, note that this will change from April 2027, as mentioned previously - so you will need to rethink this either now or in the next few years.

Make gifts during your lifetime: Gifting assets to your loved ones during your lifetime is one of the simplest ways to reduce your IHT liability:

• You can gift up to £3,000 per year without this money being subject to IHT. Unused allowances from the previous year can be carried forward, increasing this allowance to £6,000.
• You can also give as many smaller gifts of £250 per person as you wish, providing that you haven’t used another IHT exemption on the same person.
• Wedding gifts of up to £5,000 for children and £2,500 for grandchildren are also exempt.
• Gifts made more than seven years before death – known as potentially exempt transfers (PETs) - are typically IHT-free. If you die within seven years of making the gift, IHT is due on a sliding scale. If you die within three years, the full 40% rate applies, falling to 8% if you die six to seven years after the gift.

Take out life insurance: If you’re aware that your estate will breach the IHT threshold, you could take out a whole of life insurance policy to pay a lump sum to your family when you die. This money could be used to cover any IHT due. Make sure, though, to write a life insurance policy in trust. This way, it’ll be considered outside of your estate and can pay out without probate having been granted.

Ian Dyall, head of estate planning at wealth manager Evelyn Partners, says: “This is generally a much more efficient way of funding the liability and it solves a cashflow issue many executors face. Inheritance tax has to be paid before probate can be granted, but probate needs to be granted before the assets in the estate are released.”

Invest in AIM shares: AIM shares allow you to invest in smaller companies, which may come with IHT benefits. Some of these shares qualify for business property relief, which means they are exempt from IHT.

However, note that this will change from April 2026 as part of an IHT crackdown. The government is reducing the rate of business property relief to 50% for shares designated as “not listed” on the markets of a recognised stock exchange, such as AIM. This means an IHT rate of 20% will apply.