Solving The Inheritance Tax Riddle

If we have one conversation these days, it’s about inheritance.

To be specific: how to structure wealth to avoid the worst of draconian new rules – and direct as much of it as possible towards intended recipients?

We have plenty of answers, as we hope to show below.

Inheritance in their sights

It wasn’t always thus. For years, client meetings were more holistic. But recently, because of changes to legislation, about three in every four meetings attempt this new inheritance riddle.

That’s when the last two Budgets landed. They’ve changed inheritance quite profoundly.

The big thing is that most unused pension funds will be liable for inheritance tax (what we call IHT) from April 2027. In other words, when HMRC assesses your IHT liability, they may wrap your pension into their calculations, depending on which type of pension that you have.

The latest data say IHT nets the Treasury almost £7bn a year. That figure’s been rising, as you can see below. When they start taking pension money, those green bars will surely creep up further.

Just to recap, IHT typically takes 40% of your estate above £325,000 (an allowance known as the nil rate band). There are of course caveats: for example, the estate can pay inheritance tax at a reduced rate of 36% on some assets if you leave 10% or more of the estate’s total value, minus any debts, to charity in your will.

You should also know about an additional allowance worth £175,000 called the residence nil rate band. If you own your own property, and then leave it to lineal descendants, your total tax-free allowance can increase to £500,000 (namely the £325,000 + £175,000). This tapers (reduces) for estates worth more than £2 million, at a rate of £1 for every £2 over the threshold. So, an estate valued at £2.35 million or more would lose the allowance entirely.

According to the census 2021 by the Office of National Statistics, the average private pension pot for wealthier people in the UK is £637,500. So, it doesn’t take much arithmetic to recognise you may have an issue when the rules change.

Inheritance Insulation

That’s the scary stuff out of the way.

The good news is that you have time, and we have the expertise to help. We alluded above to the frequent, complex and successful conversations we’ve had over the last 13 months or so.

Let’s start.

Our assumption is you’re in the mid to latter stages of middle age, have built a good-sized pension pot and wish to structure your wealth efficiently. If you’re younger and want some ‘getting started’ guidance, skip to the last few paragraphs, where we outline some general tax planning rules.

Take the Lump Sum

You can usually take 25% of your total private pension pot, tax free. The age you can do this depends on your scheme’s rules.

We often see clients taking this full 25%, if suitable for their circumstances. Doing so will immediately lower the size of your overall pension, potentially reducing your IHT liability.

Say you have a pot of £637,500, and you’ve already used your £325,000 IHT nil rate band allowance against your pension pot. Your 40% IHT payment on this pot would be £125,000.

But, if you take out your 25% lump sum, and place it outside of your estate (such as spending and not investing in things that ping right back into the estate), your pension drops to £478,125, of which £153,125 will be liable for Inheritance Tax of £61,250. That’s less than half what you would have paid without taking the lump sum.

Tax planning is chiefly about doing your utmost to duck beneath a given tax band – to attract a lower rate – or get within a certain tax-free allowance. That’s all we’re doing here.

What do you do with your lump sum? Some spend, some save, many do both. You have lots of options.

Gifting

Giving money away, what’s called gifting, can also affect your IHT calculation positively.

You can gift £3,000 a year – thanks to an annual exemption – and, if you don’t use it, you can carry this allowance forward one year. You’re also allowed to make small gifts of up to £250 per person.

You must make gifts seven years before you die for those gifts to be free of IHT. If you die before then the rate of tax you pay tapers downwards. There are also exceptions: you can gift as much as you like to your spouse or civil partner, to charity and to political parties.

Again, this is all about reducing the sum HMRC will use to calculate your liability.

Business relief

If you’ve got a business, that’s also part of your estate. But you may be able to use Business Relief to reduce or eliminate IHT on some of your firm’s assets. These are property and buildings, unlisted shares and machinery.

There’s a cap of £2.5 million (effective 6 April 2026) and you can also share the relief between spouses.

If you are in scope here, we urge you to discuss it with us – some clients are already using it very successfully.

Trusts

Lastly, no matter what your IHT liability, have a think about life insurance – and placing the policy in trust.

Let us explain you die, the policy pays out and the sum goes to your loved ones, enabling them to cover their IHT payments. The important thing is to place it in a trust that sits outside of your estate – so the HMRC calculators can’t include it. Trusts can be very complex territory, and financial advice is essential here.

Insurance comes in different shapes and sizes. Have a think about term assurance, which pays out if you die within a specified period. One cost-effective way of addressing the problem for older clients is policies ending at age 85 to 90 – although be mindful that medical underwriting, life assurance age limits and terms can all affect the price you pay.

Whole of life insurance is another option but it’s more expensive. And the premiums tend to rise as you get older.

It’s all designed to reintroduce more flexibility in your inheritance planning.

General principles for your wealth journey

If you’re starting out – and beginning to realise our tax system is complex, I’m with you all the way.

Maybe we have the right amount of complexity – because it means you have lots of helpful options. The main one is structuring your income.

It starts off simply: Your personal allowance is £12,750, where income is free of tax. From there to £50,270 you pay 20%, and from there to £125,140 you pay 40%.

But then it gets messy: Earnings of £100,000 and above reduce your allowance at a rate of £1 for every £2 over £100,000. So, if you earn £100,002 your tax-free allowance falls to £12,749, and so on.

Simple arithmetic means an income of £125,140 or more creates a zero allowance. Oh, and at that point you’re also slapped with income tax at 45%. That’s in England and Wales – Scotland has slightly different bands.

Dividends currently attract tax 33.75% if you’re a higher tax rate payer. The rate will go up to 35.75% from next April. You also have a £500 tax-free dividend allowance. It used to be higher… but we are where we are.

If you’re in a civil partnership or marriage have a look at the marriage allowance. Here, you may be able to transfer up to £1,260 of your personal tax allowance to a higher earning spouse, depending on your circumstances. This could reduce their tax by up to £252.

Try to bear two things in mind when it comes to income:

• stay below tax thresholds if you can, seeking lower tax rates of tax or tax-free allowances, and
• keep an eye on all your income – or work with us to stay on top of it – and make sure you don’t stray up and beyond a threshold by mistake.

As you build wealth over time, it’s important to review your arrangements regularly, using tax efficient vehicles: pensions (still very useful, despite inheritance matters, above), individual savings accounts and – in certain cases – riskier vehicles like enterprise investment schemes or venture capital trusts.

This is where we come in. It’s not easy to put the right amounts, in the right vehicles, at the right time for the right duration. It’s hard to see the wood for the trees with tax at the best of times.

As our tax system is complicated we would always recommend speaking to an expert who can take your circumstances into consideration in order to provide a long-term solution for you, and your family’s individual needs and objectives.

Call us on 020 7467 2700 or email hello@firstwealth.co.uk.

First Wealth (London) Limited is an appointed representative of Best Practice IFA Group Limited, which is authorised and regulated by the Financial Conduct Authority, the registration number is 223112.

This article is for general information only and is aimed at retail clients.

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