5 IHT mistakes that could cost you thousands

Important information - the value of investments and the income from them can go down as well as up, so you may get back less than you invest.

2. Not considering the £2m limit

It’s relatively well-known that you can pass on an additional £175,000 IHT-free if you give your main home to your direct descendants (children or grandchildren). This is known as the main residence nil-rate band.

For a couple, the allowance is even more generous as they can pool their main residence nil-rate bands to pass on an extra £350,000 IHT-free.

However, you can get tripped up if you’re not also aware that, for estates worth more than £2m, this allowance starts to taper off - known as the “taper threshold”.

For people in this position, the main residence nil-rate band drops by £1 for each £2 the estate is above the threshold.

That means an unmarried person who passes on their main home to a direct descendent would see their main residence nil rate band taper away to zero once their estate is worth more than £2.35m.

Their estate would face an IHT bill of £810,000 because the main residence nil rate band has disappeared. Whereas, an unmarried person with an estate worth £2m (who can therefore make full use of the £175,000 main residence nil rate band) would face an IHT bill of around £600,000.

In the first scenario, the estate is worth £350,000 more but, because of the taper, this has resulted in additional IHT of £210,000 - wiping out most of the extra value of the estate.

A married couple that passes on their main home to a direct descendent would see their main residence nil rate band taper to zero once their estate is worth more than £2.7m.

Now clearly having an estate that is worth more than £2m is no “mistake”. The pitfall here is not thinking ahead to see whether anything can be done to mitigate the extra bill.

For example, families could look to gift money to reduce the value of their estate that is over the £2m threshold. If they can gift so that the value of the estate falls to £2m or less, then they will be able to retain their main residence nil rate band.

If they go on to live another seven years after making the gift, it should be completely IHT-free. If they do not, then it will fall back into the value of their estate for IHT purposes but will not be counted when calculating the value of the estate for the £2m taper threshold.

3. Not using the downsizer addition

You might assume that if you sell your home - for example, to downsize or to move into a care home - that you would lose some or all of the main residence nil rate band.

However, that is not always true. You may still be able to use your allowance if you qualify for what’s called a “downsizing addition”.

You can claim this if:

• the person sold, gave away or downsized to a less valuable home, on or after 8 July 2015
• the former home would have qualified for the main residence nil-rate band if they’d kept it until they died
• their direct descendants inherit at least some of the estate

With the downsizing addition, the main residence nil rate band will usually be the same as if the former home was still in the estate.

Not claiming the downsizer addition can be very costly. Take two examples.

Margaret sells her £400,000 family home to move into a care home. She puts the proceeds of the sale into her investments and leaves her entire estate of £700,000 to her two children when she dies.

Although she no longer owned a qualifying residence at death, she had previously owned one and sold it after 8 July 2015.

Because she left equivalent assets (the savings from the sale) to her children, her estate qualifies for the downsizer addition.

Her estate can claim the full £175,000 main residence nil rate band, plus the standard £325,000 nil rate band, meaning £500,000 of her estate is tax-free.

IHT is only due on the remaining £200,000, resulting in a tax bill of £80,000 (assuming she has no allowance from a spouse to use too).

Alan is in the same position as Margaret. However, when he dies his estate does not claim the downsizer allowance. This means £375,000 of his estate is liable for IHT, resulting in a bill of £150,000 - nearly double that of Margaret’s.

Remember that you must make a claim for the downsizing addition within two years of the end of the month that the person dies.

4. Not having a will

Dying without a will in place can be extremely costly as it means you lose control over how your estate is divided up and can no longer make sure this happens in the most tax-efficient way.

Let’s look at an example. David has a wife, Sarah, two children, and an estate worth £1m. If David died without a will, the laws of intestacy apply. That would mean Sarah would get up to £322,000 in assets, half of the rest of the estate (so in this case: £339,000) and all of the personal possessions of the deceased. The children are entitled to a share of the half of the estate above £322,000, which here would be £339,000.

Transfers to a spouse are exempt from IHT so no tax would be due on Sarah’s £661,000 inheritance. However, transfers to children are only covered by the £325,000 nil-rate band allowance (assuming the main home does not pass onto them). In this scenario, the children’s £339,000 allowance is over the nil-rate band by £14,000 - which is taxed at 40%, leaving them with an IHT bill of £5,600.

Whereas if David had a will in place, he could have passed the full £1m onto Sarah tax-free. When Sarah dies, she would also be able to pass on £1m tax-free because she can use both her own and David’s nil-rate bands (a combined £650,000) plus the main residence nil-rate band for both of them (a combined £350,000) if she passes on the family home to the children. 

5. Living as joint tenants or tenants in common

Unfortunately unmarried couples typically enjoy much less generous allowances than married couple or civil partners.

When an unmarried couple owns a home together, their IHT liability can grow even further depending on whether they own the home as joint tenants or tenants in common.

When an unmarried couple owns a home as joint tenants, each person owns the whole property jointly and there are no defined shares. When one owner dies, the other automatically inherits the entire property and the inherited share may be subject to IHT if the estate exceeds the nil-rate band (£325,000). When the second owner dies, the estate will again be subject to IHT if it exceeds the nil-rate band.

Say, for example, there is an unmarried couple called Hamish and Katherine who have a £600,000 home and £200,000 each in savings. If Hamish died, his £300,000 share of the property and £200,000 of savings would transfer to Katherine, incurring IHT of £70,000. Katherine now has a £600,000 property and £330,000 in savings. If Katherine and Hamish had children and Katherine leaves her £930,000 estate to them when she dies, there will be another IHT bill - this time for £172,000. So the couple's estate will have paid £242,000 of IHT in total. 

Whereas, if a couple owns their home as tenants in common, each person owns a defined share of the property (e.g. 50/50 or 70/30). There are no automatic rules about inheritance, so when one owner dies, their share passes according to their will or intestacy rules. This gives more scope for estate planning to be more IHT-efficient.

In the Katherine-Hamish example, they could each leave their individual share of the property to the children. This would enable them to each make the most of their nil-rate band and make the most of the main residence nil-rate band.

When Hamish passes away, if he leaves his share of his property to the children, there would be no IHT to pay. Assuming Katherine then died with a £300,000 share in the property and £400,000 in savings, the estate would have an IHT bill of £80,000 - £162,000 less than in the first example.

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• Read: 5 common IHT scenarios - from best to worst
• Read: 7 steps to pass on a portfolio
• Read: Autumn Budget: inheritance tax and other possible changes
• More on passing on wealth