Five estate planning banana skins to avoid

Seeking ways to reduce a potential inheritance tax (IHT) bill can be a savvy endeavour. By planning effectively, you can prevent HMRC from grabbing a large chunk of the assets you've worked so hard to accrue. And given IHT is charged at a hefty 40% on anything above your tax-free thresholds (or isn’t exempt from the tax) it can have a significant impact on your loved ones.

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But as you may have found, the IHT system is fiendishly complicated in parts. Knowing about the tax-swerving loopholes is one thing but using them efficiently is another. One misstep and your seemingly prudent estate planning strategy could end up in vain.

If you’re concerned your heirs might be landed with a large bill once you pass, and are exploring ways to remedy this, here are five banana skins to watch out for.

1. The rules around taper relief

It’s somewhat reasonably well known that gifting an asset can receive taper relief - which means the rate of IHT reduces over time - if you die within seven years from when it was made. Here’s how the taper works:

But what’s perhaps less well understood is that this sliding scale only applies to the value of gifts above your nil rate band (NRB) - the amount you can pass down tax free - which is currently £325,000.

If total amount you give away is within this figure, then instead of taper relief, you purely use up a percentage of your NRB.

So, if you passed down asset worth £260,000 in July 2017, when the NRB was £325,000, and you died in June 2023, you would have used up 80% of your NRB. As the NRB remained frozen over this period, it means that a further £65,000 of your estate can be passed on tax free.

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But if the NRB had increased to say, £500,000, the tax-free amount remaining would be £100,000 (£500,000 x 80% = £400,000).

Clearly, this calculation can get more complicated if you given several assets away spanning multiple years and the combined value exceeds your NRB.

2. Not qualifying for the residence nil rate band

The residence nil rate band (RNRB) grants some homeowners an extra £175,000 to pass on tax free. As this applies per person, it means that, as both the NRB and RNRB are transferrable between married couples and civil partners, you could have combined tax-free threshold of £1 million. 

But, unlike the standard NRB, not everyone gets the RNRB. And it’s crucial to check whether you do or not when working out your potential IHT liability. Getting this wrong could hike your heirs’ tax bill by up to £140,000.

So what are the rules here?

First, you must leave your home to direct descendants. This includes children, grandchildren or other lineal descendant, and spouses or civil partners of a lineal descendant - including their widow, widower or surviving civil partner. It also includes step and foster children. But any other relatives, such as cousins, nieces and nephews, aren't captured under the rules.

The second point to watch out for is that the RNRB reduces by £1 for every £2 an estate exceeds £2 million. Therefore, there's no RNRB if everything is own is worth more than £2.35 million on death, or £2.7 million of you’ve inherited an unused RNRB from a deceased spouse or civil partner.

3. Beware gifts with reservation of benefit

Giving stuff away is one of the simplest and most potent ways to save your heirs a hefty tax bill. But if you take this approach, you must make sure you relinquish all benefits of the asset in question - or else you could get caught out by the gift with reservation of benefit (GWROB) rules.

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For instance, let’s say gift the family home to your children to remove it from your estate. In this scenario, to escape IHT in seven years’ time, you must either move to another property or stay put and pay your children a market rent. If neither of these happen, HMRC may deem the property never left your estate under GWROB rules.

Another example is a holiday home. If you give it your offspring but continue to use it every now and then but don’t pay anything for the pleasure, it might be considered a GWROB.

4. Be careful not to give too much away

The temptation to get rid of things you own is natural given the top rate of IHT is, as noted above, a lofty 40%.

But there’s a delicate balance to struck between giving stuff to younger generations and making sure you retain enough to live a comfortable retirement.

The seven-year rule can make this tricky. You'll want to start parting with assets when you’re young and healthy to make sure you live long enough for it drift outside your estate and escape IHT.

But at the same time, it’s possible that you might need this wealth in the future, either to provide some additional income or foot care home bills, which can be exorbitant.

Either way, it’s important not to let the tax tail wag the estate planning dog. By all means find ways to thin your  IHT bill, but try to avoid plunging yourself into financial hardship in the process.

5. Choosing the wrong type of trust

For those who are happy to lose ownership of an asset but want to retain a degree of control, and perhaps still want to enjoy some benefits, trusts can be a great option.

Simply put, they are legal arrangement that allow you to move assets outside of your estate without gifting them outright. The asset usually doesn't receive immediate IHT relief – the seven-year rule on gifting applies - and you appoint trustees (one of whom can be yourself) to manage the assets and distribute them when they see fit.

However, trusts come in many different types and are complex – so you must choose carefully here.

For example, bare trusts are straightforward to manage and are low cost. On the flip side, they’re extremely inflexible, and any beneficiaries can break the trust at age 18 and seize control of the assets, which might not be ideal.

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Discretionary trusts, meanwhile, are far more expensive and complicated to run, but offer greater flexibility. For example, you can add or remove beneficiaries to suit changing circumstances.

With some arrangements, such as discounted gift trusts, you can lose access to the capital, helping to reduce your IHT liability, but still enjoy a regular income to support your retirement lifestyle. In some cases, they can also provide some immediate relief from IHT.

These are just a selection of the many different types of trusts available. When choosing the right one, it’s essential to think about the goal you are trying to achieve and get some expert help from a solicitor, accountant, financial adviser or preferably a combination of all three. Selecting wisely could save you a lot of bother down the line.