What is inheritance tax and how much could it cost you? 

At a glance

• Inheritance tax is levied on the estate of a deceased person, although relatively few estates are liable.
• Working with a professional financial adviser can help to reduce an inheritance tax bill.
• Nutmeg offers a range of products that you can use to put your inheritance to work.

Inheritance isn't a pleasant subject, and for most, neither is tax. Combined, it's often something we don't want to think about, particularly during a challenging period in people's lives. It's therefore a good idea to learn about inheritance tax before you need to do something about it.

When a person dies, the assets they leave behind form their 'estate'. Inheritance tax is charged on the estate left, but only if it exceeds a certain threshold, and only if it does not pass to a spouse, a civil partner, or a charity or community amateur sports club. Certain assets are also fully or partially exempt. This guide should set you in the right direction, with specific exemptions linked to on the Government website.

What is inheritance tax? How does inheritance tax work and who pays it?

IHT is charged at a rate of 40% of the value of assets above the threshold known as the 'nil-rate band' – the boundary beyond which IHT becomes payable. It is paid out of the deceased’s estate, rather than by the beneficiaries who inherit from it, and the executor of the will is responsible for administering the payment. 

The nil-rate band

The current ‘nil-rate band’ for inheritance tax is £325,000. This threshold has been frozen since the 2009/2010 tax year, while house prices and wages have risen. That means more families are finding that estates are liable for the tax. Even so, according to the Institute for Fiscal Studies, in 2023/24 only around 5% of estates were forecast to be liable for inheritance tax.

Main residence allowance

As well as the £325,000 threshold there is a separate main residence allowance, also known as the residence nil-rate band. This allows you to pass on your home to your children (including adopted, foster or stepchildren) or grandchildren with no inheritance tax to pay up to £175,000 of its value. Your overall allowance for inheritance tax could therefore increase to £500,000 when including the value of your home. 

Inheriting from a spouse or civil partner

When a spouse or civil partner dies, the estate can be transferred between the couple without incurring any inheritance tax, and they also inherit both the nil-rate bands for the whole estate and for the main residence. Because of this, some families can pass down an estate worth a total of £1 million without paying any inheritance tax. 

If you’re married or in a civil partnership and your estate is worth less than your threshold, any unused threshold can be added to that of your partner when you die. 

When the nil-rate band starts to taper

For estates with a net value of more than £2 million, the £175,000 residence nil-rate band is reduced by £1 for every £2 the estate value exceeds £2 million. The same applies to the second nil-rate band if applicable.

When does inheritance tax need to be paid?

If inheritance tax is due, it must generally be paid six months after the person’s death, although there are different dates if you are making payments on a trust. If not, HMRC can start to charge interest on the tax owed. If assets such as property need to be sold to pay the bill, the tax can be paid in equal annual instalments over a 10-year period, but interest usually applies.

What’s taxed? 

You might think you know what your ‘estate’ is worth, but not all your assets are counted as part of your estate for inheritance tax purposes. 

Almost everything, including money in the bank, any investments and property you own, and even some gifts you have recently given away, is counted when totting up its value. Your pension is not currently included in this figure, but the government has proposed bringing pensions into inheritance tax from April 2027.

All this means that investors, as well as those who have the bulk of their money in property, need to understand how IHT works and plan for it. It also means that the role of pensions in passing on wealth is changing.

Reducing your family’s inheritance tax bill 

Planning with a professional tax adviser can help you to bring down a potential inheritance tax bill and maximise the amount you can leave to the next generation.  

Ways to protect your estate from inheritance tax may include:  

• Giving money away 

Money or assets that are given away more than seven years before you die are not counted as part of your estate for inheritance tax purposes.  

You can also make use of an annual allowance to give away money each year that will not be included in inheritance tax calculations, even if you die before seven years is up. You can currently give away a total of £3,000 per year that will not attract inheritance tax. 

• Leaving assets to a spouse 

As mentioned above, leaving your estate to a spouse or civil partner does not attract inheritance tax and allows them to inherit your inheritance tax allowances, increasing their ability to pass down money later. 

• Leaving your main home to direct descendants

The main residence nil-rate band adds £175,000 to the untaxed portion of your estate, but only if you leave your home to a child or grandchild, including foster, adopted or stepchildren. 

• Investing using a pension 

Assets remaining in your pension are not currently counted as part of your estate for inheritance tax purposes and can be passed down to your children or other beneficiaries inheritance tax-free, depending on the amount passed down and the age of death. As mentioned above, there are proposals to bring pensions into inheritance tax from 2027.

• Giving to charity 

By giving money to charity, you can reduce the inheritance tax bill and support a good cause at the same time. Not only are gifts to qualifying charities exempt from inheritance tax, if you leave at least 10% of your net estate to charity the rate at which you pay inheritance tax on the remainder can be reduced to 36%. 

What should you do when you receive an inheritance?

It can be difficult to know what’s best to do with an inheritance. This is often a challenging period in people's lives, so it pays to take some time over the choices available to you. A financial adviser will be able to help you navigate inheritance tax. Nutmeg offers a restricted financial advice service that offers investment recommendations on our products and services, as well as a free financial guidance service. If you would like to discuss your financial goals, you can book a free call with one of our experts.  

1. Take stock of your finances 

When presented with an unexpected amount of cash, it’s human nature to start imagining how to spend it.

It's best to pause and review your finances more critically first. Start by considering any debt you have, beginning with any loans, credit cards or similar products that are costing you money in interest. If you’re being stung by interest, paying off some or all of this debt could have an immediate positive impact on your financial situation.

If you’re buying a home on a mortgage, it may not be possible or sensible to pay off the whole balance. You could consider paying off some of the mortgage, if you feel the result would ease pressure on your household finances, either by reducing your monthly payments or moving you significantly closer to paying the mortgage off altogether. Remember to check whether your mortgage provider will charge any early repayment charges, though.

Next, consider how prepared you are should something unexpected happen, causing a need for extra money urgently. For example, what would happen if you were to be made redundant, or you had to pay out for emergency repairs to your home?

We suggest that people work out how much their monthly outgoings are and hold at least three months’ worth of these outgoings in cash separate from any investments, for situations just like these. 

2. Research your cash options

Take some time to think about what proportion of your existing cash and the inheritance money you’d like to keep in cash, and do some research into the places you could leave it. You might want to put some into a ‘fixed saver’ account for a set number of years to ensure that you don't spend the money too quickly, while another portion is in an easy access account so it stays at your fingertips.

Remember that money kept in cash is vulnerable to rising prices, otherwise known as inflation, which means that your returns could be reduced in real terms. You could also miss out on returns earned on investing in equities, or income provided by bonds. Historically, equities have outperformed cash over the long-term. Remember that past performance isn't a reliable guidance to future performance and that with investing, you may not get back the amount you invest.

3. Put your inheritance to work

Once you’ve decided what to spend and what to save in cash, you can start to think about what to do with the rest of your money – what it can really achieve over the long term if you put it to work.

There are many different ways you can choose to invest your money, and it’s worth doing your research. A stocks and shares ISA is often the first port of call to access the markets, because it’s accessible and tax-efficient.

If you’re thinking about retirement – and with retirement, it’s always a good idea to start early – then a personal pension could be a good choice. Pensions benefit from tax relief, meaning the government effectively tops it up for you.

Risk warning 

As with all investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you invest. The above does not constitute tax advice or recommendations. Tax rules vary by individuals status and may change. If you are unsure if a pension is right for you, please seek financial advice.