How Does Inheritance Tax Work: A Case Study That Could Save You Millions

There are plenty of legitimate strategies that can help reduce this amount, but the catch is you need to start early. In this article, we show you how, as a follow up piece to the previous multi generational wealth planning article.

Inheritance tax (IHT) can be a huge burden on an estate, and it poses one of the biggest challenges from a tax planning perspective. Those challenges aren’t necessarily because the tax is complicated, but more so that there are few last minute solutions.

And unfortunately, far too many people leave it too late. They put off thinking about their own passing until it’s imminent, at which point there are very few planning options on the table for IHT.

Inevitably, that means hundreds of thousands, or even millions, of pounds evaporated into the coffers of HMRC. That can have a real, concrete impact on family legacy and the opportunities available to future generations.

So, it’s well worth planning for. In this article we’re going to be going into the details of how IHT works and some strategies to mitigate it. This isn’t a brief overview, and if you’re not looking for an overly technical article, then this one might be a better option to start with. 

You’ve been warned!

On the other hand, if you want to really understand how this tax works, and you’re prepared to put in work to save your family potentially millions in tax (that’s not hyperbole, we’ve got examples later), this is going to be one for you to bookmark.

How does Inheritance Tax work?

Inheritance tax in the UK is a tax that’s levied against the assets of an estate when someone passes away. It can be a serious chunk of money, because the standard IHT rate in the UK is 40%. 

That 40% rate isn’t levied on the entire estate, as there are some allowances (known as ‘Nil Rate Bands’) and exempt assets. The standard Nil Rate Band (NRB) is £325,000 per person, with an additional £175,000 available to those who own their main residence and intend to pass it on to direct descendants. This additional amount is known as the Main Residence Nil Rate Band (MRNRB).

IHT is assessed on an individual, but married couples and those in civil partnerships are able to pass on their unused NRB to their surviving partner. So for a couple who leaves everything to each other and owns their own home, that means the total amount in the estate that can be free of IHT is up to £1 million.

Anything above that amount is subject to Inheritance Tax. So while IHT isn’t only for the mega wealthy, it’s also not something that impacts those with less financial means. Interestingly, only around 4% of people in the UK who pass away each year have to pay IHT.

Quick additional note, pension assets are exempt from IHT. More on that later.

Case Study: What does the real impact look like?

Talking percentages always makes things seem a little abstract, so let’s have a look at some real numbers.

Let’s consider Anton and Lydia, who are aged 70. Their son Felix has started to speak to them about multi-generational family planning, and they don’t like the idea of so much of their hard earned wealth going in taxes on their passing. 

Here’s how things stand for them right now:

Let’s look at an example, with an elderly couple who have the following assets:

As it stands right now, Anton and Lydia’s estate will need to pay over £1.5 million in tax. That’s a huge amount of money that’s going to be sent off to HMRC, rather than being passed down to their children and grandchildren.

We’re going to stick with Anton and Lydia as we work through some of the strategies for mitigating IHT, to show the real world impact of how these can help.

Strategies to reduce Inheritance Tax

We’re going to explain some of the most useful strategies for managing IHT, and talk through the pros and cons of each. Of course, these aren’t all going to be relevant for everyone.


This is the simplest and most obvious, but even so there is a lot more to the details of gifting that most people think. 

For smaller amounts, there is an annual gifting allowance that is automatically outside of the estate for IHT purposes. This is an amount of £3,000 per person, meaning Anton and Lydia could each gift Felix £3,000 each (£6,000) total every year, and this amount is discounted from any IHT calculation immediately.

There are additional gifting allowances for weddings, being £5,000 per person for the wedding of your child, £2,500 for your grandchild and £1,000 for any other person. There is also a small allowance of £250 for birthdays and Christmas gifts, as long as you’ve not used any other allowance on that same person.

Many people believe that this is where it ends, and that you’re not ‘allowed’ to give any more than that. That’s definitely not true!

Your money is yours to do with as you please, and there is no limit to the amount you can give. The only stipulation on it, is that any money that is gifted above these allowances to is deemed to be outside of an estate only if the gifter lives for a further 7 years. 

This isn’t an ‘all or nothing’ time scale, with a sliding scale on the gift applied which is called taper relief. If the gifter passes away in the first 3 years, the full amount of the gift is included in the estate for IHT calculations, but from year 3 onwards the percentage drops until it hits zero at year 7.

So if Anton and Lydia gave a gift to Felix of £200,000 it would mean £6,000 would be outside of the estate immediately (if they hadn’t already used this allowance), £196,000 would remain ‘in the estate’ for 3 years, and then after 7 it would be discounted.

You can see now why forward planning is important. Making this gift now they’re aged 70 gives a good chance that they’ll survive that 7 years, but making the gift at age 85 would make that far less certain.

To provide an example of how impactful this could be, if Anton and Lydia decided they didn’t need their investment account (more on that below), they could gift the entire £1.35 million to Felix today. After 7 years, that would mean a reduction in their IHT liability of £540,000. Pretty powerful.

Gifts from regular income

Ok, this is still gifting but it deserves its own heading because it’s criminally misunderstood. Gifts out of regular excess income are exempt from IHT immediately and there is no limit on the amount you can gift.

Yes, that’s right. If Anton and Lydia have spare cash on a monthly basis from their Buy to Let property and investments, they can gift that to whoever they want and it is outside their estate immediately.

The catch is that it does have to be genuinely from spare income and it needs to be regular.

So let’s say Anton and Lydia have final salary pensions paying them £40,000 per year, State Pension worth another £20,000 combined, plus income from their BTL of £20,000 a year. They take an additional £15,000 in income from their SIPP. That’s a combined income of £95,000 a year, and they find that is enough to meet their regular expenses.

Any income they receive that is above that amount can be given away and is immediately outside the estate for IHT purposes. So if we look at their investment accounts of £1.35m, they could place these in a high yield portfolio and generate, for example, 4% in income. That would mean £54,000 in excess income that could be gifted every year.

That’s an IHT tax saving of £21,600 every year the income is gifted.

Again it’s important to remember it’s income only. So if that same portfolio also generated capital gains of 2%, that amount would not be able to go towards the regular gift.


Trusts are not a magic solution and they offer limited flexibility. There are a couple of trust types worth considering, particularly if the person making the gift doesn’t want to lose total control over their assets.

First off, placing money into a trust is considered a gift. Gifts within the Nil Rate Band (£325,000 for an individual or £750,000 for a couple) are classified as Potentially Exempt Transfers (PETs) and fall under the same 7 year rules as regular gifting.

Any amount larger than that is classed as a Chargeable Lifetime Transfer (CLT), which means there’s an immediate 20% IHT tax charge, and potentially a further tax charge every 10 years. Without getting too deep in the weeds here, it’s almost never a good idea to make a CLT, which means gifts into trusts are effectively limited to £700,000 per couple, every 7 years.

If you’re not scared off yet, here are a couple of the most common trust types used for IHT planning  

Discounted Gift Trust (DGT)

Setting up a DGT allows you to place money into a trust while retaining the right to receive an income from the funds for the rest of your life. The 'discount' refers to this right to income, which provides an immediate reduction to your estate for IHT purposes based on your life expectancy and health.

When you pass away, the remaining assets in the trust are passed on to the beneficiaries free of IHT. So in Anton and Lydia’s case if they didn’t want to lose the income from their investment portfolio, they could gift £750,000 of it (to keep it as a PET) into a DGT and continue to receive income payments each year.

Loan Trust

A loan trust is kind of like the inverse to a DGT as you retain access to the capital but not the income and growth. A payment is still made into the trust, but in this case any capital growth or income generated by the investment is immediately outside of the estate. Because the initial capital is a loan, you’re able to take it back at any time.

So imagine Anton and Lydia were to pay £500,000 into a loan trust and leave it untouched for 10 years, let’s say it grew to £1m. The £500,000 in growth is not included in their calculations for IHT, but they could pull out any amount up to the initial £500,000 whenever they wanted to.

IHT friendly investments

Some investments are exempt from Inheritance Tax if certain conditions are met. We’ve already mentioned that pension assets are totally exempt from IHT, but there are a range of other investments which qualify for what’s known as Business Property Relief (BPR). 

Don't let the name fool you, this has nothing to do with commercial real estate, and the definition of what counts as ‘business property’ is wide. The main target of the legislation is to allow for actual businesses to be passed down to future generations.

Imagine a couple with a farm or a small retail business worth, for example, £2 million. They may have very little else in terms of assets, as many self employed plough all their investable capital back into the business. The business could have very little cash on hand.

If that asset were to pass down to someone's children, there could be an IHT bill of up to £800,000 on it. Obviously without significant additional assets, the children would be forced to break up the business and sell it in order to meet the IHT liability. That’s a poor outcome, and BPR is designed to protect against it.

Of course whenever there is an opportunity like this, there are financial products designed to utilise it, and now you can find BPR investments that offer exposure in a wide range of assets such as shares in certain listed companies, equity in private companies, infrastructure projects, business machinery, land and more. 

As long as these assets are held for more than two years, and are still held on death, they receive relief from IHT.

One of the best known asset types that qualify for BPR are shares in companies listed on the AIM market, instead of the London Stock Exchange (LSE) the main board. Of course it’s important to always validate the investment as a standalone proposition, before considering any potential tax benefits.

Life insurance

This is a bit of a crude band aid approach, but it can work in the right circumstances. Essentially this strategy simply involves purchasing an insurance policy designed to cover the amount of IHT payable.

For example, Anton and Lydia could take out an insurance policy that provides a benefit of £1,558,000 which would offset their expected IHT liability. The main downsides to this strategy is that the optimal level of cover is going to be very expensive, and the IHT liability may rise above the level of cover over time.

It’s very important that the proceeds from this policy are directed to a trust, otherwise the benefit is added straight to the estate and will attract IHT itself!

Charitable Giving

The final strategy to discuss is charitable giving. First off, any gift made to a charity is immediately outside the estate for IHT purposes, i.e. there is no ‘7 year rule’ for charitable gifts of any amount.

Secondly, if you leave at least 10% of your net estate to a charity in your will, your estate is able to reduce your IHT rate from 40% down to 36%.

This has a much bigger impact than you might think. To demonstrate, let’s take a final look at Anton and Lydia.

So in this case, Anton and Lydia are able to give a gift of £389,500 to their charity of choice, which reduces their IHT liability by £297,020. That means that the net cost of the gift to their estate is just £93,480.

The importance of communication

As you can see, there are actually many different ways to reduce a potential IHT liability, and it doesn’t simply involve giving up access to all of your assets. With the right strategies, families can ensure that the older generations have sufficient assets to provide them with everything they need throughout their lives, while also ensuring the maximum amount passes to future generations.

Of course often the difficult part of managing money across multiple generations isn’t the nuts and bolts of the tax strategy, but the emotional and communication side of things. We understand that at Rosecut, which is why we’ve written this guide to having open communication about multi-generational family planning.

If you’d like to talk in more detail around your own family's financial circumstances, speak with us today.

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