What is inheritance tax (IHT)?
More families face paying inheritance tax (IHT), but what is it and who has to pay the levy?
Inheritance tax (IHT) is firmly under the microscope as more families brace for paying the so-called “death” tax due to frozen bands, rising house prices and legislative changes.
In the 2022/23 tax year, 4.62% of UK deaths resulted in an IHT charge, up 0.23 percentage points on the previous financial year, according to the latest data from HMRC.
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IHT receipts look set to hit a record high this financial year, with a total of £7.1 billion collected by the Treasury in the 10 months to January. That’s £130 million higher than the same period in the 2024/25 financial year (£7 billion).
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. In some circumstances, it’s also due on gifts made within seven years of someone dying.
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 IHT is payable on £100,000, not the total value of your estate.
However, the amount of IHT you pay isn’t always 40% above the threshold as there are different rules and allowances that impact your tax liability.
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 means 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.
Do note, you start to lose your residence nil-rate band if your estate is valued at £2 million or more. For every £2 your estate is worth more than £2 million, you lose £1 of this residence nil-rate band until it disappears. This means estates left by a single person worth £2.35 million receive no residence nil-rate band, while for couples it’s £2.7 million.
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 the 2024 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, said the announcement was “largely expected” as the inheritance tax exemption for pension pots “is something of an anomaly”.
Some experts 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 inheritance tax (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.
There have been calls to raise this six month window to 12 months, where pensions, family businesses and farms are involved, to allow more time to settle IHT bills.
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.
How to reduce an inheritance tax bill
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 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, so you will have to start rethinking this strategy soon unless you want your loved ones footing a bill.
Do note, you should ideally be filling in an expression-of-wish form which decides how any unused funds from your pension are distributed if you die.
Make gifts during your lifetime
You can avoid inheritance tax by giving away assets to your loved ones during your lifetime. Note that if your gifts are outside the inheritance tax gift allowances, you may need to pay inheritance tax, if they're given less than seven years before death.
- You can gift up to £3,000 per year without this money being subject to IHT. This is known as the annual exemption. 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 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, said: “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.
Access your pension sooner
With pensions falling under the scope of IHT from April 2027, you may want to start accessing your pension pot sooner rather than later.
Just make sure you have a plan in place so you’re not left out of pocket later into retirement.
There is growing evidence more pensioners are starting to draw from their pots earlier or turn to annuities or whole of life insurance policies to offset ahead of the changes from April 2027.
