Inheritance Tax: Understanding the Allowances That Shape Family Outcomes

Inheritance tax is often encountered as a single headline figure. For many families, it is framed simply as a 40% charge applied to wealth on death. In reality, the system is far more layered. Beneath the headline rate sits a structure of allowances, thresholds and conditions that have been built up over time and applied in a specific order, and when those layers are not fully understood, the difference between expectation and outcome can be substantial.

Small details often have an outsized impact: how a home is passed on, whether allowances are claimed correctly, or whether gifts made years earlier have already reduced what is available. To explore how inheritance tax works in practice, we spoke with Michelle Holgate, Director and Wealth Manager at RBC Wealth Management, who helps families understand how these layers interact and why decisions made during life can materially change the final outcome.

The Nil Rate Band: A Foundation That Is Often Misread

At the core of inheritance tax sits the nil rate band. Each individual currently has an allowance of £325,000 that can be passed on at death without inheritance tax being due. Anything above that threshold is generally taxed at 40%. While this figure is widely known, the way it operates in practice is frequently underestimated.

The key point is that the nil rate band does not exist in isolation. Gifts made during the seven years before death are taken into account and can reduce the allowance available, meaning families may have less tax-free capacity than they expect ^[1]. The allowance is also transferable between spouses and civil partners, allowing unused amounts from first death to be carried forward and claimed on second death ^[2].

As Michelle explains:
“Each person has £325,000 that on their death can be gifted away without inheritance tax being due, but what people often miss is that gifts made in the seven years before death are taken into account.”

The Residence Nil Rate Band and Its Conditions

Alongside the standard nil rate band sits an additional allowance linked to the family home. The residence nil rate band provides up to £175,000 per person, but it comes with strict conditions that regularly catch families out.

To qualify, the property must be passed to direct descendants, such as children or grandchildren. Crucially, the allowance is also subject to a taper once the overall estate exceeds £2 million, reducing by £1 for every £2 above that threshold. In practice, this can result in the allowance being reduced or lost entirely.

What makes this particularly complex is that some assets which sit outside the estate for inheritance tax purposes still count towards the £2 million calculation. As Michelle notes,
“Some assets don’t trigger inheritance tax themselves, but they do sit within the calculation for whether the residence nil rate band is reduced.”

For families close to the threshold, this interaction can have a disproportionate effect on the final tax position.

Where Families Most Often Miss Opportunities

In practice, inheritance tax inefficiencies tend to arise not from complexity alone, but from lack of awareness. Many families are simply unaware of how many allowances are available or how they can be used together.

Annual gifting allowances, gifts on marriage and charitable donations are often underused ^[3]. More significant opportunities exist through gifts made from surplus income, where regular excess income can be passed on without using any inheritance tax allowance, provided the gifts are genuinely habitual and properly documented ^[4].

Pensions are another frequent blind spot. They are governed by expressions of wish rather than a will, and if left unchanged, pension wealth may be unintentionally channelled to a surviving spouse and later become subject to inheritance tax, particularly as the rules surrounding pensions continue to evolve.

Seeing Inheritance Tax as a Structure, Not a Number

A meaningful shift occurs when families stop viewing inheritance tax as a single charge and start seeing it as a broader structure. When income tax, pensions and intergenerational planning are considered together, more flexible and effective solutions often emerge.

Michelle describes scenarios where paying income tax earlier can reduce inheritance tax exposure later. Drawing income at a higher tax rate and passing it down to the next generation can allow that money to be recycled more efficiently, for example through pension contributions in the children’s names.

“If you look at inheritance tax in isolation, you miss opportunities,” Michelle explains. “When you understand how the layers work together, you can often improve outcomes for the whole family.”

Communication, Timing and a Changing Landscape

One of the most persistent challenges in inheritance tax planning is a lack of communication. Financial decisions are often made in isolation, without considering how allowances might be used across generations.

This can result in wasted allowances, duplicated tax exposure and missed planning windows. Timing also matters. With pensions currently sitting outside the estate for inheritance tax purposes but scheduled to be brought into scope under future changes, strategies that work today may not remain effective indefinitely ^[5].

As Michelle puts it, “the tax landscape is constantly changing, and wealth planning needs to be adaptable rather than fixed.”

Planning for Movement, Not Certainty

Inheritance tax planning is not a one-off exercise. It sits at the intersection of income tax, capital gains tax, pension rules and family dynamics. Treating it as static rarely produces the best outcome ^[6].

By understanding how the allowances fit together and by revisiting plans as circumstances and rules change, families can make more informed decisions and ensure that wealth is passed on intentionally, rather than shaped by default.