Inheritance Tax: Nil-Rate Bands, the 7-Year Rule and Your Estate

01 How inheritance tax works

Inheritance tax (IHT) is charged on the value of your estate — your property, savings, investments and possessions, less any debts — when you die. Everyone has a nil-rate band of £325,000 that's taxed at 0%; anything above your available allowances is taxed at 40%. That's the whole engine: add up what you own, subtract your allowances, and 40% of what's left is the bill. The art of inheritance tax planning is simply maximising the allowances and shrinking the taxable remainder.

The £1 million allowance is commonly assumed to apply to everyone, and it does not. It is reached only by a married couple whose home passes to direct descendants and whose estate is under £2 million — three conditions, each of which can fail independently. A single person leaving their home to a niece has £325,000, not £500,000.

Source: GOV.UK — How Inheritance Tax works

02 The residence nil-rate band

On top of the £325,000 nil-rate band there is an additional residence nil-rate band of up to £175,000, which applies when you leave your main home — or assets up to its value — to direct descendants: children, stepchildren, adopted or foster children, and grandchildren.

That is what lifts a single person's potential allowance to £500,000, and a couple's to £1 million once both bands transfer. It is also the source of most of the confusion here, because it does not apply automatically.

Three conditions catch people out. It requires a residence you actually lived in at some point, so a buy-to-let never occupied does not qualify. It requires the property, or value up to it, to pass to direct descendants — leaving the house to a sibling, a niece or a friend forfeits it entirely. And it tapers away for larger estates at £1 for every £2 above £2 million, so an estate of £2.35 million or more receives none of it.

That taper creates a sharp effective rate. Between £2 million and £2.35 million, each extra £2 of estate removes £1 of allowance taxed at 40%, producing an effective marginal rate of about 60% on that band — well above the headline 40%, and the reason estates near £2 million plan hardest.

Source: GOV.UK — Residence nil rate band

03 The spouse exemption and transferable bands

Anything you leave to a UK-domiciled spouse or civil partner passes completely free of inheritance tax, however large the estate. There is no cap and no seven-year wait.

Just as importantly, any nil-rate band and residence nil-rate band the first partner does not use transfers to the survivor. That is why a married couple or civil partnership can effectively combine two £325,000 bands and two £175,000 residence bands into a £1 million allowance on the second death.

Two practical points follow. The transfer is expressed as a percentage of the band unused, not a cash amount — so if the first death used none of it, 100% transfers and is applied at whatever the band is worth when the second death occurs, not what it was worth decades earlier.

And it must be claimed. Executors of the second estate apply for the transferred bands, normally within two years of the second death, and they need evidence from the first estate: the death certificate, the will, and the grant of probate. Where the first death was thirty years ago and the paperwork has been lost, establishing the claim becomes difficult and occasionally impossible — which makes keeping those documents one of the highest-value pieces of admin in estate planning.

Unmarried couples get none of this. There is no spouse exemption and no transferable band between cohabiting partners, however long they have lived together, which is the single largest inheritance tax disadvantage of not marrying.

04 Gifting and the 7-year rule

You can also reduce the estate by giving wealth away during your lifetime. Most gifts are potentially exempt transfers: live seven years after making one and it falls entirely outside your estate.

Die within seven years and the gift is counted back. Taper relief reduces the tax on gifts made between three and seven years before death — but it reduces the tax on the gift, not the value of it, and it only bites once the gift has used up the nil-rate band. That distinction disappoints people regularly: a £100,000 gift made four years before death, with a full nil-rate band available, gets no benefit from taper at all.

Several exemptions sit outside the seven-year rule and are worth using every year, because they largely cannot be carried forward. The annual exemption is £3,000. Small gifts of up to £250 per person are exempt, to any number of people. Wedding gifts have their own limits, larger for a child than a grandchild. And gifts out of surplus income — regular, made from income rather than capital, and not reducing your standard of living — are immediately exempt with no seven-year wait, which for someone with a large pension income is the most powerful and most underused relief available.

05 Pensions and the 2027 change

Pensions have long been one of the most powerful inheritance tax tools, because unused pension funds have generally sat outside the estate. That let a well-advised retiree spend other assets first and pass the pension on efficiently.

That is changing. From 6 April 2027 the government plans to bring unused pension funds within the estate for inheritance tax, which removes the structural advantage that made pensions the last asset to touch.

The consequence is a genuine reversal of the standard drawdown order. Under the old treatment the sensible sequence was to spend ISAs and taxable savings first and leave the pension untouched. If pensions become estate assets, that logic weakens considerably, and for larger estates it may invert.

Two cautions. The rules are not yet in force and the detail has been consulted on, so anything restructured now is being restructured against a moving target. And decisions driven purely by inheritance tax frequently cost more in income tax than they save — drawing a pension down faster to shrink an estate means paying income tax at your marginal rate now, possibly 40%, to avoid 40% later.

The sensible position before 2027 is to understand the change is coming, avoid locking in irreversible decisions based on the old treatment, and revisit the order in which you draw on each pot — the trade-off between a guaranteed income and a flexible one is worked through in Annuity vs Drawdown — once the final rules are known.

06 Reducing the bill

Beyond the bands and the spouse exemption, several levers can cut the eventual tax:

• Make full use of gifting — the annual £3,000 exemption, gifts out of surplus income, and larger gifts made early enough to clear the seven years.
• Leave money to charity — gifts to charity are exempt, and leaving 10% or more of your net estate to charity cuts the rate on the rest from 40% to 36%.
• Use trusts and certain reliefs — business and agricultural reliefs, and trusts, can help in the right circumstances, but they're complex and need professional advice.
• Revisit your plan before 2027 — especially how pensions fit, given the coming change.

The full decision is in Pension Drawdown: How to Take a Sustainable Income.

07 What each allowance is worth, and what forfeits it

Four allowances do most of the work, and three of them can be lost by accident.

The third row goes wrong most often in practice. Transferred bands are not automatic — executors of the second estate must claim them, with evidence from the first, which may be decades earlier. Keeping the first spouse's probate paperwork can be worth up to £500,000.

Source: GOV.UK — Inheritance Tax