Inheritance Tax Explained — A Plain-English Guide

Inheritance Tax (IHT) is one of the most misunderstood taxes in the UK. It affects fewer estates than most people think, but the bills can be enormous when it does apply. This guide explains how IHT works in 2026, what the thresholds are, and the legitimate strategies available to reduce it.

What is Inheritance Tax?

Inheritance Tax is a tax on the estate (property, money, and possessions) of someone who has died. It is charged at 40% on the value of the estate above the tax-free threshold. The tax is paid by the estate before assets are distributed to beneficiaries — not by the beneficiaries themselves.

In the 2024/25 tax year, approximately 4.4% of UK deaths resulted in an IHT charge, generating around £7.5 billion in revenue for HMRC. The number of estates caught is rising, largely because property values have increased while the nil-rate band has been frozen since 2009.

The nil-rate band: £325,000

Every individual has a nil-rate band (NRB) of £325,000. The first £325,000 of your estate is tax-free. Everything above that is taxed at 40%.

The NRB has been frozen at £325,000 since 2009 and is confirmed frozen until at least April 2030. In real terms, it has lost roughly 40% of its value to inflation since it was set. This “fiscal drag” is the primary reason more estates are falling into the IHT net each year.

The residence nil-rate band: £175,000

If you leave your main home (or a share of it) to direct descendants (children, grandchildren, stepchildren), you can claim an additional residence nil-rate band (RNRB) of £175,000. This brings the total individual threshold to £500,000.

There are important conditions:

• The property must be (or have been) your main residence
• It must be left to direct descendants — leaving it to siblings, nieces, nephews, or friends does not qualify
• The RNRB tapers away for estates worth more than £2,000,000. It reduces by £1 for every £2 above £2m, disappearing entirely at an estate value of £2,350,000
• The RNRB is also frozen at £175,000 until at least April 2030

Transferable allowances between spouses

Married couples and civil partners can transfer unused allowances to the surviving spouse. If the first spouse to die uses none of their NRB (because everything passes to the surviving spouse tax-free under the spouse exemption), the full £325,000 NRB transfers to the survivor.

Combined with the RNRB, a married couple can pass on up to £1,000,000 completely free of IHT:

Transfers between spouses (during life or on death) are always exempt from IHT, regardless of the amount. This is the spouse exemption — one of the most valuable IHT reliefs available.

Gifts and the 7-year rule

You can give away assets during your lifetime to reduce the value of your estate. These gifts fall into several categories:

Potentially Exempt Transfers (PETs)

Any gift to an individual (not to a trust) is a Potentially Exempt Transfer. If you survive for 7 years after making the gift, it falls completely outside your estate and is free of IHT. If you die within 7 years, the gift is added back to your estate and potentially taxed.

Taper relief

If you die between 3 and 7 years after making a gift, taper relief reduces the IHT rate on that gift:

Annual exemptions and small gifts

Several gifts are immediately exempt from IHT — no need to survive 7 years:

• Annual exemption: £3,000 per year. You can carry forward one unused year, so up to £6,000 if you didn’t use last year’s allowance.
• Small gifts: Up to £250 per recipient per year, to any number of people (but not to someone who has already received part of your £3,000 annual exemption).
• Wedding gifts: £5,000 to a child, £2,500 to a grandchild, or £1,000 to anyone else, given on or before the wedding day.
• Normal expenditure out of income: Regular gifts made from your surplus income (not capital) that don’t affect your standard of living. This is potentially unlimited but must be genuinely habitual and from income, not savings. Examples: paying a grandchild’s school fees, regular contributions to a child’s ISA, or paying life insurance premiums.
• Gifts to charities: Always exempt, with no limit.
• Gifts between spouses/civil partners: Always exempt, with no limit.

Business Relief

Business Relief (BR, formerly Business Property Relief) allows qualifying business assets to be passed on with reduced or zero IHT. The relief rates are:

• 100% relief: Shares in unlisted trading companies, a business or interest in a business (sole trader or partnership)
• 50% relief: Shares in a listed trading company where the deceased had a controlling interest, land or buildings used in a business the deceased was a partner in or controlled

The assets must generally have been owned for at least 2 years before death.

AIM shares: changes from April 2026

Shares listed on the Alternative Investment Market (AIM) have historically qualified for 100% Business Relief, making them a popular IHT planning tool. From April 2026, this is changing significantly:

• AIM shares will only qualify for 50% relief (down from 100%)
• The combined value of Business Relief and Agricultural Property Relief qualifying for 100% relief is capped at £2,500,000 per person (transferable between spouses/civil partners, so up to £5m for a couple)
• Above this cap, the relief rate drops to 50%

The cap was originally announced at £1m in the Autumn Budget 2024 but was increased to £2.5m in December 2025. If you hold AIM shares for IHT planning, you should review your strategy in light of these changes.

Agricultural Property Relief

Agricultural Property Relief (APR) works similarly to Business Relief but applies to agricultural land and buildings. The relief is either 100% or 50%, depending on the type of tenancy and ownership arrangement.

From April 2026, APR is subject to the same £2,500,000 combined cap with Business Relief for the 100% rate (transferable between spouses, so £5m for a couple). Above this threshold, the relief rate drops to 50%. This primarily affects larger farming estates and has been controversial in the agricultural community.

Pensions and IHT: the April 2027 change

This is arguably the biggest change to IHT in a generation. Currently (2026/27), unused defined contribution (DC) pension pots sit outside your estate for IHT purposes. They can be passed to beneficiaries free of IHT (though beneficiaries pay income tax on withdrawals if the holder dies after 75).

From April 2027, unspent DC pension pots will be brought into scope for IHT. This means:

• Your pension pot will be added to the value of your estate when calculating IHT
• If your total estate (including pensions) exceeds the available nil-rate bands, the excess will be taxed at 40%
• Beneficiaries will still pay income tax on pension withdrawals, creating a potential double taxation scenario

For example, consider someone with a £400,000 house, £200,000 in ISAs, and £500,000 in pensions. Currently, their estate for IHT is £600,000 (house + ISAs), and with the NRB + RNRB (£500,000), the IHT bill is £40,000. After April 2027, the estate becomes £1,100,000, and the IHT bill jumps to £240,000 — a six-fold increase.

Life insurance written in trust

A life insurance policy written in trust pays out directly to your chosen beneficiaries, outside your estate. The proceeds are not subject to IHT and are typically paid within weeks (whereas obtaining probate on an estate can take months).

Many people take out a “whole of life” policy specifically to cover their estimated IHT bill. For example, if you estimate your estate will owe £200,000 in IHT, a whole-of-life policy for £200,000 written in trust ensures your beneficiaries receive the full value of your estate without having to sell assets to pay the tax.

The premiums for the policy can qualify as “normal expenditure out of income” if paid regularly from surplus income, making them themselves exempt from IHT.

Charitable giving and the 36% rate

If you leave at least 10% of your net estate (after deducting the nil-rate band and any reliefs) to a registered charity, the IHT rate on the rest of your estate drops from 40% to 36%.

This can be surprisingly cost-effective. Consider an estate worth £825,000 with a £325,000 NRB. The taxable estate is £500,000. At 40%, the IHT bill is £200,000. If you leave 10% (£50,000) to charity, the remaining £450,000 is taxed at 36% = £162,000. Your total outgoing (charity + tax) is £212,000, leaving £613,000 for beneficiaries instead of £625,000 — a cost of just £12,000 to give £50,000 to charity. The charity effectively receives £50,000 at a net cost to your beneficiaries of £12,000.

Trusts: a brief overview

Trusts can be useful IHT planning tools, but they are complex and come with their own tax charges. The most common types for IHT planning are:

• Discretionary trusts: Assets are held by trustees for the benefit of a class of beneficiaries. Transfers into a discretionary trust above the NRB are immediately chargeable at 20% (half the death rate). The trust is also subject to periodic charges of up to 6% every 10 years.
• Bare trusts: The beneficiary has an absolute right to the trust assets. Transfers into a bare trust are PETs (potentially exempt after 7 years). Simpler but less flexible.
• Life interest trusts: One person receives income from the trust during their lifetime, then the capital passes to other beneficiaries. Often used between spouses.

Trusts add complexity and ongoing costs (trustee responsibilities, annual tax returns, potential 10-yearly charges). They are most useful for larger estates or specific family situations. Professional advice is essential.

Practical IHT planning strategies

Here are the most effective, legitimate strategies for reducing your IHT bill. Many can be used in combination:

1. Use your annual exemptions every year

£3,000 per year doesn’t sound like much, but over 20 years of retirement that’s £60,000 removed from your estate — saving £24,000 in IHT. A couple can give away £6,000/year, saving £48,000 over 20 years. Add in £250 small gifts to multiple recipients and the numbers add up.

2. Make gifts from surplus income

The “normal expenditure out of income” exemption is potentially the most powerful IHT relief available, because it’s unlimited and takes effect immediately (no 7-year wait). If you have surplus income — income that exceeds your normal living expenses — you can give it away regularly without any IHT consequences. Keep meticulous records: HMRC will want to see that the gifts were habitual, from income (not capital), and didn’t reduce your standard of living.

3. Spend your money

This sounds obvious, but many retirees are reluctant to spend their savings. Every pound you spend on yourself — travel, experiences, home improvements, gifts to family during your lifetime — is a pound that can’t be taxed at 40% on your death. Enjoying your retirement is the simplest form of IHT planning.

4. Consider your drawdown order carefully

Before April 2027, it’s generally tax-efficient to spend non-pension assets first and preserve your pension (which sits outside the estate). After April 2027, this changes. You may want to draw down your pension more aggressively and preserve ISAs (which are in the estate but can be passed on without income tax). The optimal ordering depends on your specific estate size and the relative values of your pension, ISAs, and other assets.

5. Write life insurance in trust

If you have an IHT liability that can’t be eliminated, a whole-of-life policy written in trust ensures your beneficiaries receive the funds to pay the bill without selling the family home or other assets.

6. Leave 10% to charity

If you’re charitably inclined, the 36% rate makes giving very cost-effective. Even if you’re not planning a large charitable gift, it’s worth running the numbers to see if the reduced rate benefits your beneficiaries overall.

7. Equalise estates between spouses

If one spouse has a much larger estate than the other, consider transferring assets so both spouses can make full use of their nil-rate bands and annual exemptions. The spouse exemption means transfers between married couples are always IHT-free.

Key takeaways

• IHT is charged at 40% on estates above the nil-rate band (£325,000, frozen until 2030)
• The residence nil-rate band (£175,000) adds to this if you leave your home to direct descendants
• Married couples can combine allowances for up to £1,000,000 IHT-free
• Gifts become exempt after 7 years; taper relief applies between 3 and 7 years
• Annual exemptions (£3,000), small gifts (£250), and gifts from surplus income are immediately exempt
• Business Relief for AIM shares reduces from 100% to 50% from April 2026, with a combined £2.5m BR/APR cap per person (£5m for couples)
• DC pensions will be brought into scope for IHT from April 2027 — a major change
• Leaving 10%+ to charity reduces the IHT rate to 36%
• Life insurance written in trust can cover the IHT bill without burdening beneficiaries
• Start planning early — the 7-year rule means time is your most valuable asset