How to avoid inheritance tax traps

1. Ignoring the nil rate band and residence nil rate band

To reduce a potential IHT bill, you need to understand how the tax works. The first step is familiarising yourself with the twin allowances: the nil rate band worth £325,000, and residence nil rate band worth up to an extra £175,000 for your main home.

Your estate – which includes everything from your savings, ISAs and property to valuable art, jewellery and cars - will be subject to IHT if, when you die, it exceeds £325,000. The surplus above this threshold is taxed at up to 40%.

However, anything you leave to a spouse or civil partner is free from IHT as this counts as an exempt transfer, and they also inherit any unused nil rate band.

This means on the second death (the death of the remaining spouse or civil partner), up to £650,000 of the estate could avoid IHT as the nil rate bands are added together.

In addition, if you’re passing your main home to direct descendants such as children or grandchildren, you’re entitled to a further £175,000 allowance – known as the residence nil rate band. Note that the residence nil rate band begins to taper away for estates over £2 million.

If the family home passes from the surviving spouse to a direct descendant on the second death, a further £350,000 is potentially available (as the £175,000 residence allowances are combined). So, in total, up to £1 million of assets could be inherited tax free.

It’s important to get your head around how the allowances – and who you choose to leave your wealth to – can influence a potential IHT bill.

Ignoring the nil rate bands could mean your beneficiaries face an unnecessarily large IHT liability. Review your will to see if you can take advantage of the allowances, such as leaving your home to your children.

2, Assuming gifts will automatically reduce the value of your estate

Gifting assets during your lifetime is a well-used technique for reducing the size of the estate, but there are pitfalls.

Some people believe that once a gift is made, there’s no IHT liability. However:

•    If you die within seven years of making a gift, it could be added back into your estate and be liable for IHT.
•    If you gift an asset but continue to get benefit from it (for example you keep living in a property you’ve given away), it may count as a “gift with reservation” and remain inside your estate for IHT purposes.
•    If you’re gifting from income, you need to follow strict rules (and keep a record of gifts made), otherwise these could be subject to the seven-year rule.

To avoid this trap, make use of the £3,000 annual gifting allowance, which allows you to give away up to £3,000 a year in total free of tax. You can also gift up to £5,000 for a child who is getting married, £2,500 for a grandchild, and £1,000 for someone else, such as a niece, nephew or close friend. These sums immediately leave your estate and are not liable for IHT. These gifts towards marriage or civil partnership do not count towards your £3,000 annual allowance.

If you’d like to give away more, consider doing so soon to get the seven-year clock ticking as quickly as possible. Make sure you weigh up giving cash or assets away with ensuring you have enough money for yourself both now and in the future.

It’s also possible to make regular payments to someone from your monthly income. However, to ensure these payments are free of IHT, you must be able to afford them after meeting your usual living costs – in other words, the money must be truly “surplus” to your own needs. You should keep records showing the gifts are regular and don’t impact your lifestyle.

3. Overlooking the IHT treatment of pensions

Pensions have long been one of the most tax-efficient vehicles for retirement and estate planning, but there are changes ahead.

Currently, pension pots are typically outside the saver’s estate for IHT purposes. However, from 6 April 2027, most unused pension funds and death benefits will be treated as part of someone’s estate and be liable for IHT.

The reform is still over a year away – and as with most things in politics, the rules could be tweaked in the meantime - so avoid making knee-jerk decisions around your financial plans. However, it makes sense to think about how your pension pots will integrate into your overall estate, and what that could mean for a future IHT bill.

Review your pension drawdown strategy and consider all options as we get closer to April 2027.

4. Failing to plan for agricultural and business relief changes

Farmers and business owners often rely on agricultural property relief (APR) and business relief (BR) to protect their estates, but upcoming reforms will change the rules significantly.

For many years, these reliefs provided 100% relief from IHT for qualifying assets. In the 2024 Autumn Budget the government announced the 100% relief would apply only up to a £1 million allowance per person (combined across APR and BR), with effect from April 2026.

However, fast forward to December 2025, and after a sustained backlash from farming businesses, the government announced the threshold (the allowance) would rise to £2.5 million.

This means, from 6 April 2026:

•    The 100% relief will apply only up to a £2.5 million allowance per person (combined across APR and BR). 
•    Any value above £2.5 million will qualify only for 50% relief (in other words, an IHT liability on half of the asset value).
•    Shares in companies designated as “not listed” on the markets of recognised stock exchanges (such as AIM shares) will only be entitled to relief at 50%, rather than 100%.
•    Spouses and civil partners are allowed to pass up to £5 million (£2.5 million for two people) in qualifying agricultural or business assets between them before paying IHT, on top of existing allowances.

If you own a farm or business, now is the time to review ownership and succession plans. Consider whether lifetime transfers (before the change takes effect) make sense, and revisit wills and trusts as required.

5, Forgetting to consider how your loved ones will pay an IHT bill 

Even well-planned estates can stumble if the right provisions aren’t in place for beneficiaries to pay an IHT bill.

The tax is due within six months of the end of the month of death. Some estates consist primarily of assets that aren’t readily convertible, such as farmland, business interests and property. If there is not enough money to pay the tax, beneficiaries may be forced to sell other assets in a hurry, sometimes to their detriment.

If you think liquidity will be a problem for your loved ones, consider taking out whole of life or fixed term life insurance written into trust. This is designed to provide a cash lump sum on death to pay the IHT.

Taking a holistic view

Inheritance tax planning isn’t just about writing a will or making a gift. It requires a holistic view of your estate, any business or farming interests, plus intergenerational aspirations.

With the upcoming changes to pensions and agricultural/business reliefs, it’s an ideal time to speak to a financial adviser. An adviser can explain the reforms, help you avoid any inheritance tax traps, and put plans in place so you leave more of your money to your family, and less to HMRC.

The levels and bases of taxation and reliefs from taxation can change at any time. Tax relief is dependent on individual circumstances.

Will writing involves the referral to a service that is separate and distinct to those offered by St. James's Place and along with Trusts are not regulated by the Financial Conduct Authority.