Investment - Articles - Six costly inheritance tax mistakes families must avoid

‘IHT liabilities are expected to soar 67 per cent by 2030/31, and we are seeing among our clients a lot of concern about their beneficiaries being landed with large IHT bills, especially with the cap on business reliefs this year and looking forward to pensions being taxed. That must reflect the growing worries of families more widely across the UK.

‘More people are becoming aware of the IHT risk hanging over the carefully saved assets they hope to leave to their loved ones, but the danger is that in trying to side-step IHT, they come a bit of a cropper. Because the rules around IHT can be difficult and confusing, we would always recommend that anyone who thinks their estate faces a substantial IHT bill - or has a complex range of assets or distinct family circumstances - seeks professional advice before they start making any big moves.

‘We see a lot of mistakes made by people who have not thought about IHT or tried to take DIY steps to mitigate a future IHT bill. Hopefully, this list will help raise awareness of some of the pitfalls around IHT, and the passing on of wealth during lifetime or at death.’ 

1. Failing to make or update Wills properly
Dyall says: ‘It is essential to review and update Wills and Trusts regularly, particularly after major life events such as divorce, marriage, or the death of a beneficiary. Failing to do so can result in assets passing to unintended beneficiaries and may also create unnecessary tax liabilities.

‘If you don’t have a Will then making one can be a big step in establishing financial security and peace of mind for your family. It can prevent unnecessary stress and even disputes for the administrators and beneficiaries of an estate and could save them having to pay unnecessary IHT bills. Those who have complex affairs should get their solicitor to work closely with a good financial planner.

‘Having Wills in place is especially crucial for unmarried couples in long-term relationships - as the intestacy rules could lead to an unwelcome distribution of assets at death - and for blended families where uncertainty and misunderstanding can arise. Where the family home is not jointly owned, that could also create issues at death, and couples should consider how their property is owned at the same time as looking at Wills. (See point 5 below.)

‘Even where Wills are in place, and especially if they were made some time ago, make sure that they still do what you want them to, and that new tax rules do not require a rethink. Lots of Wills made a long time ago but currently in place won’t take account of the significant changes to IHT in recent years.

‘The introduction of the residential NRB in 2016 is still catching people out because it only applies if a home is left to a direct descendant such as a child or grandchild. The rules can extend this definition to step-children, adopted and even fostered children, for instance, but it’s evident that care needs to be taken in drawing up Wills and Trusts so that the £175,000 RNRB is used effectively.

The value of each spouse’s estate is also important to consider, because if either spouse is worth over £2m on their death, their nil-rate band will be tapered away and cannot be used, or transferred to their surviving spouse.  If all the assets are in one spouse’s name, rearranging the assets may lead to a tax saving of up to £140,000.

‘For families who own businesses, the recent cap on business and agricultural property relief, which has been in effect since the start of this financial year in April, could demand a major rethink of how business assets are left at death in order to take most advantage of the available reliefs.

‘Another note on paperwork: pension savers should check the expression of wishes, or death benefit nomination, they have made on their workplace and personal pensions. With the inclusion of unused pension assets in IHT calculations from next April, the spousal exemption will be the only way to protect these savings from IHT. So in many cases it will make sense - from an IHT perspective at least – to have the spouse as the nominated beneficiary rather than children.’

2. Over- and under-estimating IHT – and forgetting your own needs
Dyall says: ‘Before anyone starts giving money away with an eye on reducing or eliminating a future IHT bill, they should do their homework or take advice on what allowances and exemptions they are entitled to, as their potential IHT liability might not be as great as feared.

‘Also, fundamentally, they need to be comfortable that they can afford to give assets away without jeopardising their own future financial security. It is important that retirees make sure their own needs and desires are catered for before distributing their wealth. This can be a tricky calculation, and our clients value the clarity that professional cash-flow modelling can provide in showing the future impact on retirement income of gifting.

‘They should also make sure that, in an effort to mitigate IHT, they are not paying excess tax by gifting - for instance if they face higher income tax on pension withdrawals or capital gains tax on selling investments.

‘Post-death, valuation issues can become paramount. The number of investigations by HM Revenue & Customs has increased recently, with a focus on undervaluation of high-value assets, particularly property. So personal representatives need to be more careful than ever that their IHT calculations are based on a reasonably accurate estimate of the estate’s value. For instance, for a property, seek two independent valuations.

‘When calculating the value of the estate it is normally the open market value on the date of death, net of any debts, that should be used.  Most debts – including outstanding mortgages - are deductible for IHT purposes provided they are repaid on death. If the value of listed shares or property reduces whilst the estate is being administered, then relief against IHT can be claimed on the reduced value - within 12 months for shares and three years for property.

‘Gifts can also cause issues at the valuation stage as personal representatives need to consider the impact of any outright gifts or transfers to Trust in the seven years prior to death, and records are not always complete. These gifts will be deducted from the NRB allowance (£325,000 for each individual), leading potentially to a higher IHT liability on the rest of the estate. If the gifts in the last seven years exceed the NRB, then the recipients of the later gifts may have a liability on what they received.

‘One final complication that can catch out personal representatives, and lead them to underestimate IHT, is the RNRB taper. This reduces the RNRB allowance by £1 for every £2 if the net value of an estate exceeds £2 million. This tapering reduces the available RNRB to zero for individuals with estates worth over £2.35 million, or £2.7 million for couples with brought-forward allowances.’

3. Gifting blunders: Reserving benefits and not keeping records
Dyall says: ‘Gifting is probably the area where casual efforts to reduce an IHT liability without taking professional advice most often backfire. There is considerable confusion over the rules, which admittedly are complex.

‘Many people believe that they can solve their IHT liability simply by putting the family home in their children’s name and continuing to live in it as they did before. If they do that, the property will never leave their estate for IHT purposes, and its value will be subject to 40 per cent IHT on their death. Unfortunately, for capital gains tax purposes the children will be seen as the owners and any gains made between when it was gifted to them and when they sell it will be subject to CGT of up to 24 per cent for higher and additional rate taxpayers.

‘To make the gift of the property effective in reducing their IHT liability they will either need to move out or pay a market rent to their children, and the children would then be liable to income tax on the rent. If your children live with you, it is possible to give them a reasonable share of the property (not all of it) and provided you pay at least your share of the running costs, the gift should reduce your IHT liability. However, for both parent and child, this is not often a realistic or palatable option for simply mitigating tax.

‘If you gift cash or assets (above the quite limited annual gifting exemptions) it is usually treated as a “potentially exempt transfer” (PET) and, provided you live for seven years after making the gift, it will no longer form part of your estate, and so be clear of IHT. However, if you continue to use the asset, or the gift can be taken back if you choose to do so, then HMRC will deem there to be a “reservation of benefit” and the gift will continue to form part of your estate indefinitely. It is possible to make the gift effective by paying for the use of it, but it must be at the market rate rather than a nominal payment.

‘Some people have tried to avoid the rule by selling their home, giving the money to the children to buy a new home which the parents then live in. This potentially may avoid the reservation of benefit rules, as the parents never owned the new home, but if it does it is likely to be caught by another piece of anti-avoidance legislation called POAT (pre-owned asset tax).

‘Most people who fall foul of the legislation are simply oblivious of the rule that you cannot continue to benefit from an asset you have given away. It doesn’t just apply to property: assets gifted but held in Trust could still be subject to IHT if the donor (gifter) is named in the Trust as a potential beneficiary, as that constitutes a reservation of benefit.

‘Finally, anyone gifting with an eye on mitigating IHT should keep good records showing the date and value of gifts, and who received them – not least because this will make life a lot easier for their personal representatives. This is especially the case with more complex gifting strategies like the “normal expenditure out of income” exemption which is sometimes used by grandparents paying private school fees.’

4. Confusion over ‘potentially exempt transfers’ and taper relief
Dyall says: ‘Taper relief for gifts made within the seven-year period of a PET is not quite as straightforward, or generous, as it may sound.

‘A common misconception is that taper relief automatically reduces the tax bill on any gift if the donor survives for three to seven years, under PET rules. Taper relief only applies to the portion of gifts that exceed the available NRB. If cumulative lifetime gifts, over the last 7 years, remain within the NRB, taper relief does not apply.

‘Additionally, when calculating IHT, gifts made within seven years of death are deducted from the NRB first, which can reduce the allowance available to offset the rest of the estate.

‘If the gifts put together exceed the NRB then taper relief can apply, which reduces the tax paid on older gifts. If there were three-to-four years between date of gift and death, the IHT rate lowers to 32 per cent, while at six-to-seven years the rate falls to just 8 per cent. All of which means that large gifts exceeding the NRB can moderate IHT liability even if the donor does not survive for seven years.

‘All this means that some donors casually assume that any gift will be entitled to tapered relief - this is not the case. Plus, PETs and failed gifts can leave a surprise for beneficiaries who find that they owe tax on it if the donor does die within seven years. If a gift above the NRBs does become liable for IHT, it is the recipient who will have to pay the bill, and even though they might get taper relief, they may not have the resources to meet the tax bill, possibly having spent the money.

‘If a gift is below the NRBs, and the donor dies within seven years, then all the beneficiaries of the estate could share the liability on the lifetime gift received by one person, which could cause friction.

‘So, when making sizeable gifts to multiple children, try to ensure that they receive the gifts on the same day – which could well be Christmas Day or thereabouts. This is because gifts use exemptions and allowances in the order they are made, so if they are made on different days to different children, the earlier gifts get the benefits of all the allowances and the later gifts suffer the tax.’

5. Forgetting you’re not married...
Ian says, ‘Long-term, unmarried co-habitees can suffer some really unwelcome consequences if one of them dies before they have given proper thought to the IHT rules. They do not have the privilege of the spousal exemption - or the spousal transfer of the NRB or RNRB* - and therefore their only protection against IHT is a single person’s £325,000 NRB. Where valuable homes are concerned this can cause real problems.

‘The worst situation is where the home is in the name solely of the deceased, which means the whole value will be included in the estate. For a fully paid-up £1m property that will mean the surviving partner will have to find a minimum (before any other assets are considered) of £270,000 to pay the IHT bill – 40 per cent of £675,000. It is not uncommon for the surviving partner to be forced into selling the home in these circumstances.

‘Even where the home is jointly owned, a co-habiting couple might not realise that – as they are unmarried - the share of the property that is left to the surviving partner will deplete or wipe out their NRB on its own, leaving all other assets exposed to IHT.

'Marriage and civil partnership have certain tax benefits in the UK, but the spousal exemption from IHT at death is probably the most powerful, and that will be even more valuable when unused pension assets fall into the IHT net next year. The only way to keep pensions free of IHT with any certainty will be to leave them to a spouse or civil partner. 

‘Our financial planners have certainly been having more discussions around marriage or civil partnership with older clients in long-term relationships since the October 2024 Budget.

‘In the case of some elderly couples, you can almost say the biggest IHT blunder would be not getting married or entering a civil partnership. Even if the first partner to die wants to leave some assets to children, they will have more NRB to protect this part of the estate if none is used for the assets left to their partner.

‘Of course, the IHT problem might arise further down the line when the surviving spouse dies. While possibly benefitting from two sets of NRBs, their remaining wealth could be inflated by the pension assets from the first death, potentially increasing IHT liability for their children or other beneficiaries – especially if they die soon after their spouse.’

6. Messing up insurance
Ian continues: ‘Expanding IHT liabilities are driving more families to take out insurance against a future tax bill, so it does not become a burden to their beneficiaries.

‘Good estate planning can effectively hold back the incoming tide of death duties, with the use of reliefs, gifting and Trusts combining to put an effective IHT strategy in place. But as the screw is being turned on reliefs and exemptions, more families and their advisers are now reaching for the security of insuring against the IHT liability, which could for instance prevent the forced sale of the family home.

‘That said, premiums for whole-of-life cover can be high and will not be suitable in every case, but even those who would benefit from insurance can make costly errors in arranging a policy. It is essential to choose the right policy and, importantly, to put it into Trust so that the payout itself does not form part of the taxable estate.

‘In practical terms, the most common way insurance is used to mitigate IHT is through a whole-of-life policy written in Trust. The cover is designed to match the expected IHT exposure after reliefs and exemptions, and is often used alongside steps to reduce a liability, such as lifetime gifting.

‘Premiums are paid during lifetime, and because the policy pays out on death whenever that occurs, the family has the security of knowing that funds will be available to pay the tax bill when it arises, preventing any forced sale of assets. The policy should be written in Trust so that the payout sits outside the estate and does not itself increase the tax liability.

‘If you are married or in a civil partnership, then a “joint life, second death” policy is usually best. Both lives are insured, but because assets pass free of IHT between spouses at first death, the policy only pays out to beneficiaries on the second death. So, there’s obviously a number of potential mis-steps for those arranging insurance on a “DIY” basis.

‘It is also important to note that whole of life comes in two forms, guaranteed and reviewable. With guaranteed policies, the premium you pay at outset never changes, so if you pay that premium until death, the sum assured will pay out. With reviewable policies the insurer will re-evaluate the holder’s situation in the future, and at that point you may get asked to pay more to maintain the same sum assured or have the sum assured reduced.

‘Guaranteed policies are more expensive but, especially with the support of cash-flow modelling, the holder should know that they have both the current and future financial legroom to afford the premiums. In contrast, we have seen some reviewable policies where the premiums have gone up sixfold.

‘It’s worth noting that a major benefit of having life insurance in place to cover an IHT bill is that it should pay out quickly after death and be available before probate is granted, making life a lot easier for executors and less stressful for family. The six-months-from-death IHT deadline will become more challenging and stressful for personal representatives when they have to deal with – potentially more than one - pension schemes from next April.

‘That now adds further appeal to the idea of having a life policy in place, and even more importance on getting it right!’

* If they have children then they could benefit from the RNRB if they leave their share of the home to the children, but if they leave it to their partner then their RNRB will not transfer and is wasted.