Many are aware of the 60% marginal income tax trap, whereby you incur an effective 60% tax on earnings between £100,000 and £125,140, due to the gradual tapering of your tax-free Personal Allowance.
For a reminder of the mechanics around this, and how to mitigate it, please see my previous blog on the subject – The marginal 60% tax trap.
However, fewer are aware of the 60% inheritance tax trap.
This can apply on certain estates valued over £2m and arises due to the mechanics of the residence nil-rate band.
The residence nil-rate band
When you die, the first £325k of your estate is free from inheritance tax (IHT) – the standard ‘nil-rate band’. However, those who leave a main residence to a ‘direct descendant’ (generally a child or grandchild), or the proceeds thereof, benefit from an additional allowance – the residence nil-rate band (RNRB) – of up to £175k (or the value of the property if lower).
As a side note here, the RNRB can still be claimed where a person sold, gave away or downsized to a less valuable home, on or after 8 July 2015. For example, say you had a £500k home but had to sell this to fund care needs in later life, you’d still be entitled to the full RNRB.
For a married couple, any unused allowances can be inherited by the surviving spouse. As a result, in most cases, the first £1m of your estate can be passed down to the next generation completely free from inheritance tax. The balance is charged at 40%, unless you leave 10% of your estate to charity, in which case you’ll benefit from a reduced IHT rate of 36% - one for a future blog.
The RNRB taper
However, where the value of your estate exceeds £2m, you start to lose your residence nil-rate band entitlement. For every £2 that your estate exceeds this threshold, your RNRB entitlement is reduced by £1.
This gives rise to a 60% IHT trap – once your estate rises above £2m, any increase will incur the standard 40% IHT rate plus an additional 20% due to the mechanics of the taper.
Consider the following example:
Jack and Kate are married and have two children.
At the start of 2023, their estate is valued at exactly £2m, comprising their main residence worth £750k, £250k in cash and a further £1m in investments. Their spending needs are fully met by their private and State Pensions, hence their investments are left untouched and free to grow.
At this point, their inheritance tax liability is estimated as follows:
Estate value: £2,000,000
Less 2x nil-rate bands: (£650,000)
Less 2x residence nil-rate bands (£350,000)
= Estate liable to IHT: £1,000,000
Less IHT@ 40%: (£400,000)
= Residual estate distributed to beneficiaries: £1,600,000
That is, their beneficiaries would stand to inherit around £1.6m, net of a £400k IHT charge.
Fast forward to today, and after a 20% increase in the value of their investments, their estate now stands at £2.2m. IHT is recalculated as follows:
Estate value: £2,200,000
Less 2x nil-rate bands: (£650,000)
Less 2x residence nil-rate bands (£250,000)
= Estate liable to IHT: £1,300,000
Less IHT@ 40%: (£520,000)
= Residual estate distributed to beneficiaries: £1,680,000
Notice the reduction in their RNRB entitlement, from £350k to £250k. This reflects the increase in estate value above the £2m threshold, in which case this is tapered by £100k (it’s reduced by £1 for every £2 excess)).
The result is that whilst the value of their estate has increased by £200k, their beneficiaries will ‘only’ inherit an extra £80k. That is, they’ve lost £120k or 60% to the additional inheritance tax charge, as a result of the RNRB tapering.
These figures are for illustrative purposes only and do not reflect actual investment returns, which can fluctuate and are not guaranteed.
Planning opportunities
The good news is that the mechanics of the RNRB taper give rise to a potential immediate 20% IHT saving on direct gifts.
Continuing the example above, say Jack and Kate were to gift £200k immediately to their children.
The gift would be subject to the standard 7-year rule, i.e. they would need to survive 7 years for the gift to no longer be liable to IHT, at which point there would be an effective saving of £80k (gift amount x 40%).
However, for the RNRB taper, the gift falls outside the estate from day one. As a result, their RNRB entitlement would be immediately increased by £100k, providing an instant IHT saving of £40k, or 20% of the gift amount.
More generally, where possible, it is tax efficient to keep the estate value below the £2m threshold, to avoid the 60% trap.
Disclaimer: Some areas of Inheritance Tax (IHT) planning are not regulated by the Financial Conduct Authority. Some IHT planning solutions may put your capital at risk so you may get back less than you originally invested. IHT thresholds depend on your individual circumstances and may change in the future.
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require in order to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
