3 tax quirks that could see your IHT bill soar

Inheritance Tax (IHT) tends to divide opinion - a progressive way to reduce inequality for some, an unfair charge on the instinct to provide for the next generation for others.

Planned changes announced in the Budget last year seem likely to add yet more scrutiny. They include changes to the exemption enjoyed by farmland, incurring the wrath of farming families and celebrity backers like Jeremy Clarkson. Of consequence to more people, however, are proposals to include pension wealth within the scope of IHT.

These will significantly expand the number of estates that incur an IHT bill, and greatly increase the bill for those already within the scope of the tax.

They are likely to draw more attention to the complicated rules for IHT. Here we highlight three quirks in the IHT system which can lead to very different outcomes from seemingly very similar circumstances.

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April 2027 - an IHT cliff-edge

IHT only begins to apply when an estate reaches a certain size. Up to £325,000 can be passed on with no IHT due. This is known as the ‘nil-rate band’. Anything over the nil-rate band can potentially face 40% tax, but there are several exemptions that can give you more headroom before the tax is due.

Firstly, money passed to a spouse or civil partner attracts no IHT at all. Furthermore, spouses and civil partners can pass unused nil-rate bands to each other. And there is a further ‘residence nil-rate band’ exemption if the estate being passed includes a primary residence - a home in which you live. This means an extra £175,000 of nil-rate band per person.

Taken together, these exemptions mean that a person could pass on as much as £1 million with no IHT to pay, as long as they have been passed an entirely unused nil-rate band from a spouse and the estate includes a primary residence.

The Budget included the proposal to include pensions within the scope of IHT as well - but only from April 2027 onwards. Until then, money held in a pension can be passed on tax-free if death occurs before age 75. If it occurs after age 75 then pension money is taxed at the beneficiary’s marginal rate.

That makes April 2027 a potentially very significant date for some people.

Imagine, for example, a person aged 73 now who will turn 75 on 6 April 2027 when the new rules begin to apply. They have £100,000 of pension wealth that they wish to pass on to their children that exceeds any nil-rate band available to them.

If they were to die before their 75th birthday then this £100,000 can go to their children without any tax to pay at all. But if they die just a day later this pension money will face two significant tax hits.

Firstly, IHT will apply, reducing the inheritance to £60,000. Then, because they have died after age 75, the money will be taxed at their child’s marginal rate. If the child was a higher-rate taxpayer then it would reduce the inheritance again to £36,000.

In other words, an inheritance of £100,000 arising from a death on the 5 April 2027 will be taxed down to £36,000 if death happens on the 6 April 2027.

Sons and daughters vs. nieces and nephews

This quirk concerns the extra IHT allowance for estates which include a primary residence. The ‘residence nil-rate band’ allows £175,000 of wealth to be passed on as long as the estate includes a family home. The rules specify, however, that this only applies to ‘lineal descendants’ - which means children or grandchildren.

So imagine the example of two people, each with estates worth £500,000 which include their home. Both are unmarried but one has a child they wish to pass their money to while the other has no children, and instead wants to pass their money to their niece or nephew.

The person with a child can pass on the entirety of their estate with no tax to pay, but the person passing money to a niece or nephew will not benefit from the £175,000 Residence nil-rate band and so faces a tax bill of £70,000.

£2m estates - and 80%-plus tax

This one also concerns the ‘residence nil-rate band’, and the fact that it is reduced and eventually removed altogether for estates that exceed £2million.

This works by the band being reduced by £1 for every £2 on an estate that exceeds £2million. Once an estate reaches £2.35million it is completely tapered away.

The plan to include pensions in estates means that potentially many more will be impacted by this and, if enacted as proposed, will create a system in which pension money in these estates could face three tax hits before beneficiaries eventually receive it.

Firstly, the money will be exposed to IHT at 40%. Secondly if death occurs after age 75, what’s left will be taxed at the beneficiary’s marginal rate of Income Tax. Finally, the IHT liability will increase again because the excess in the estate above £2million will reduce the residence nil-rate band by half the excess, exposing more of the estate to 40% IHT.

You can see how these each would reduce the value of £100,000 held in a pension within an estate that exceeds £2million and passed to a beneficiary who pays 40% tax.

• Read: IHT on pensions to push wealthy families into 80% plus tax

In this scenario, pensions money being passed on faces an effective tax rate of 84% - reducing it from £100,000 to £16,000. The effective rate could be even higher if the beneficiary pays Income Tax at more than 40%.

Tax rules can change so always ensure you are keeping within the rules at the time and consider professional advice if you are unsure about your liabilities. Our advisers might be able to help.

You can read about some of the ways you can reduce your IHT liability here.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on personal circumstances and all tax rules may change in the future. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.