Modern family tax trap explained

• interactive investor highlights the importance of having hard conversations early to avoid problems down the line

New calculations from interactive investor (ii), the UK’s leading flat-fee investment platform, highlight the importance of families having hard conversations about money – especially inheritance – to avoid problems down the line.

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The calculations reveal that young people could face rising inheritance tax (IHT) bills if they inherit from single parents, blended families or unmarried partners - emphasising the importance of prudent estate planning.

Craig Rickman, personal finance expert at interactive investor, explains: “With inheritance tax rules changing and blended families becoming more common, more grieving family members may be left with a hefty tax burden upon receiving money or assets on death.

“Broaching such a delicate subject with our nearest and dearest is never easy, but in absence of these discussions, HMRC could take a significant chunk of the family wealth and surviving loved ones may face a maelstrom of complexity when administering an estate.

“Younger people might not be aware that the amount of tax they pay on inherited assets depends on factors outside their control, including their parents’ marital status. Some valuable IHT-free allowances and exemptions don’t extend to unmarried couples.”

Key points:

• £110,000 bigger IHT bill for those inheriting from a non-relative (e.g. their parents’ unmarried partner) from April 2027 – assuming assets worth £600,000*.
• £200,000 more IHT for adult children inheriting from a single parent (who is not widowed) with a £1 million estate**, compared to £0 for those inheriting from married parents.
• £270,000 bigger bill for those inheriting from an unmarried partner compared with inheriting from married parents or a spouse (with a £1 million estate).
• £432,000 more IHT for those with a blended family, assuming they inherit from an unmarried “step-parent”** (with a £1 million estate)

*- assumes £600,000 estate with an average-valued house and enough pension for a moderate retirement.

**- assumes £1 million estate is passed first to an unmarried partner who subsequently leaves their assets to the children of their unmarried partner.

***- this assumes house worth £220,000, pension worth £330,000 (enough for a moderate retirement according to Pensions UK) and cash of £50,000.

****- this assumes house worth £450,000, pension worth £450,000 and cash of £100,000.

What families need to be aware of and start thinking about

Rickman explains: “It’s wise for families to think carefully about how they structure and grow their wealth, because inheritance tax rules can mean very different outcomes depending on family circumstances. The earlier you can understand your family’s unique situation and kickstart the planning process, the better.

“The IHT rules are fiendishly complex in parts and will become even knottier from April 2027 as unused pension savings will form part of the estate calculation. That’s why it’s so important to get expert legal and tax advice in this area, to not only understand your specific situation but also explore potential IHT-saving solutions.

“Some good first steps are to review pension beneficiaries, check how investments and assets are owned and will be passed on, and make sure your wills match your intentions. This is particularly true for single parents and blended families who may be able to harness certain IHT exemptions. Having hard conversations earlier is not easy, but can avoid stress and rushed decisions later, and give kids a clearer picture of what to expect.

“It also offers a timely reminder of the importance for adult children not to rely on an inheritance and conduct their own tax-efficient planning. Building resilience through wrappers such as pensions and ISAs can help them strengthen their finances independently, while parents review pension beneficiaries and wills to make sure wealth passes on as efficiently as possible.”

The tax traps: a deep dive

• Higher IHT bills apply to unmarried couples and families because key IHT exemptions are not available, creating a tax trap for blended families and single parents.
• Because married parents can effectively share IHT exemptions (£325,000 nil-rate band and £175,000 residence nil rate band), they can potentially pass on up to £1 million to their children or grandchildren free from IHT (note, the residence nil rate band reduces by £1 for every £2 an estate exceeds £2 million).
• However, children of single parents and blended families may not have these allowances available, exposing a greater share of their estate to the 40% rate of IHT.

Children of single parents – up to £200,000 additional IHT

Children inheriting from a single parent, not widowed, only benefit from one set of IHT allowances.

• Single parents have a single £325,000 nil rate band and a single £175,000 residence nil rate band – £500,000 tax-free in total rather than £1 million.
• Their children could therefore pay £40,000 IHT on an estate worth £600,000 (40% x £100,000).
• There is £200,000 IHT to pay on a taxable estate worth £1 million.

Unmarried partners - up to £270,000 additional IHT

Unmarried partners or those inheriting from a non-relative (e.g. their parents’ unmarried partner) could face an even larger IHT bill

• Unmarried partners only have the £325,000 nil rate band available (not the £175,000 residence nil rate band as to qualify the home must be left to direct descendants).
• They could owe £270,000 more tax than those inheriting from married parents or a spouse, assuming a £1 million taxable estate.

Blended families – up to £432,000 additional IHT

Blended families with unmarried parents face a punishing tax trap of up to £432,000. This reflects a potential double penalty for those leaving assets to unmarried relatives.

For example:

• One parent passes away, leaving £1 million to their partner. There is £270,000 IHT to pay on this first death (only the £325,000 nil rate band is available).
• The parent’s partner then also passes away and leaves the remaining £730,000 to their partner’s children. Again, only the £325,000 nil rate band is available so there is a further £162,000 IHT bill.
• £432,000 IHT has been paid in total, compared to no tax if the parents had been married.
• The adult children only inherit £568,000 of the original £1 million estate.

Note – how IHT exemptions work

• £325,000 nil rate band - this tax-free amount is available to everyone.
• £175,000 residence nil rate band - this is available to parents who leave a home to ‘direct descendants’, including their children, grandchildren or stepchildren (from a married relationship).
• Spousal exemption - spouses and those in a civil partnership can leave assets and transfer unused IHT allowances to their spouse.
• Married couples and those in a civil partnership can effectively double-up the IHT nil rate band and residence nil rate band and can therefore pass on up to £1 million tax-free to their descendants.
• Pension wealth is currently outside the IHT regime, but will be included from April 2027, significantly increasing the taxable value of many estates.