Estate Planning: Three Common UK Inheritance Tax Pitfalls to Avoid

Inheritance tax (IHT) is a levy imposed on the assets that you own after you pass away. These assets are your estate. In the UK, IHT is charged on the total value of the deceased’s estate before it is distributed to beneficiaries.

There are two key allowances that apply to UK estates:

Nil rate band (NRB) – everyone benefits from a £325,000 allowance which is free of IHT.

Residential nil rate band (RNRB) – this is an additional allowance of £175,000 applicable to main residences (not buy-to-let properties) which pass to children or grandchildren.

Together, these allowances add up to a possible £500,000 free of inheritance tax. Above that, an estate is taxed at 40%.

Married couples can transfer allowances between them to bring their total allowance to £1million. It is important that wills are structured correctly to ensure that the allowances are fully utilised.

Payment of IHT is usually required as part of the probate process before assets can be passed to beneficiaries. Without careful planning, this can cause problems if families have to pay six or seven-figure sums before assets can be unlocked.

1. Confusing the seven-year rule and the annual gifting exemption

It’s important to be clear on the gifting rules with regard to IHT. The seven-year rule means that any gift made more than seven years before death is exempt from inheritance tax, regardless of the amount.

This is completely separate from the annual gifting exemption, which allows individuals to give away up to £3,000 each year without it affecting their IHT allowance. A common misconception is that gifts are limited to £3,000 annually, but in reality, much larger sums can be given tax-free – provided the person making the gift survives for at least seven years.

For this reason, the seven-year rule is often used as part of a long-term strategy to reduce the taxable value of an estate by passing wealth directly to beneficiaries (or into a trust).

2. Disregarding the reservation of benefit

Another common misconception is believing that simply transferring ownership of an asset removes it from your estate for inheritance tax purposes. In reality, if you continue to benefit from the asset after gifting it, the value will still be treated as part of your estate.

For example, you might gift your home to your children and transfer the title at the Land Registry. However, if you continue to live there without paying a full market rent, HMRC views this as a ‘gift with reservation of benefit’. The property therefore, remains inside your estate for IHT calculations, regardless of the change in ownership.

This rule catches many families out and can add millions to estates that were thought to be protected from inheritance tax.

3. Assuming a trust is always the answer

Many people assume that placing a property or other assets into a trust is a simple way to avoid inheritance tax. However, trusts come with their own tax rules and consequences that can be more complex – and sometimes more costly – than expected.

Different types of trusts are subject to different regimes, which may involve upfront charges, ongoing tax on the value held in the trust and higher rates of income or capital gains tax compared with individual ownership. If these consequences are overlooked, the trust can end up creating a larger tax liability during your lifetime rather than reducing your estate’s exposure to inheritance tax.

For this reason, trusts should always be used as part of a carefully considered estate plan, with professional advice to ensure the structure achieves the intended outcome.

Inheritance tax is sometimes viewed as an optional tax – one that can be reduced or even avoided with the right planning. But effective strategies often need time to work, as many are subject to waiting periods before the full benefits apply (like the seven-year rule). This means that every year without a plan is a missed opportunity to protect more of your estate.

The earlier you start, the more options are available. By planning well in advance, you can use allowances more effectively, pass on wealth tax-efficiently and ensure your family benefits as you intend.

Because inheritance tax is complex, with rules that change over time, speaking to a specialist is the best way to find strategies suited to your circumstances. Taking advice now could make a significant difference for you and your loved ones in the years ahead.