Middle class families are "sleepwalking" into an inheritance tax trap

INHERITANCE tax (IHT) is no longer a problem just for the wealthy, it’s hitting middle-class families hard, especially in London.

With average London homes now worth around £658,000, many estates are breaching the £2 million taper threshold, which wipes out the Residence Nil Rate Band (RNRB) worth up to £350,000 per couple. 

Once lost, estates face a 40% tax rate on anything above the £650,000 basic allowance.

As thresholds remain frozen until at least 2030, and with the likelihood the pension will form part of the estate from 2027, more families could fall into this “hidden” tax trap.

Eamonn Prendergast, Chartered Financial Adviser at Bromley-based Palantir Financial Planning Ltd, said many Londoners are “sleepwalking” into financial crisis.

He added: "Inheritance tax is fast becoming the great middle-class trap. In London especially, ordinary families who simply bought and stayed in their homes for decades now find themselves facing six-figure tax bills. 

"The £2 million taper threshold for the Residence Nil Rate Band hasn’t moved in years, while house prices have surged and allowances remain frozen until 2030.

"Add in the potential inclusion of pensions from 2027, and thousands more estates will be pushed over the line not through excess wealth, but through inflation and inaction. The rules were designed to target the very rich, but in today’s housing market they’re catching families who never saw themselves as wealthy at all."

Luke James, Tax Director at Gravitate Accounting, said many are unaware of the tax trap.

He continued: "We’re seeing more and more clients being caught by the £2 million limit as inflation erodes its real value, often unaware of the high tax rates they now face. Insurance is sometimes considered but can be costly, and if the liability isn’t clear, cover may fall short. 

"After detailed reviews, clients are increasingly open to gifting and trusts, which allow them to retain control. This is a key factor for many wealthy individuals. The inclusion of pensions in the inheritance tax net from 2027 is another major shift, prompting clients to rethink long-term plans. 

“Many are now looking at drawing on pensions earlier, making lifetime gifts and restructuring assets. Those with SIPPs who have not sought advice could face unnecessarily high tax charges without robust planning.”

Antonia Medlicott, Founder & MD at Stonehouse-based Investing Insiders, said we are heading towards a crisis.

She added: "The average UK pension pot is now worth around £250,000. If the government presses ahead with including unused pensions in IHT calculations, tens of thousands of families will be hit with IHT bills for the first time. 

"These are families who will be blindsided by debt on what we previously would have called a ‘modest inheritance’. I'm also worried about the effect this will have on the public's appetite for pensions. 

"At a time when we're constantly being warned by experts that we're heading towards a pensions crisis, with far too few of us saving enough, this is giving terrible mixed messages. It's certainly a strange way to encourage younger people to see the benefits of saving."

Rob Mansfield, Independent Financial Advisor at Tonbridge-based Rootes Wealth Management, doubts the government will change the thresholds.

He added: "This is a ticking time bomb and the government will be rubbing their hands at the prospect of greater inheritance tax receipts. If they keep freezing the thresholds and don't build enough homes, property prices in London and the south east alone will eat up most of the allowances and so people who have undertaken sensible planning are going to be caught up. 

"For some people, I don't think it has fully sunk in that any money left in a pension will soon form part of their inheritance tax calculation. It's particularly invidious that there's no allowance for a premature death before pension access is even possible."

Ross Lacey, Director & Independent Financial Adviser at Rayleigh-based Fairview Financial Management, said there are “many misconceptions” around the tax.

He continued: “We're certainly getting more enquiries relating to IHT where people want clarity in their position. There are many misconceptions which isn't helped by the constant tinkering to tax rules and misinformation spread online. 

"The £2m threshold where the RNRB starts to get tapered is one that often catches people out. When pensions are included in estates from 2027, some will see a double whammy of the pension being taxable at 40% on death, plus another £350k of their estate (the RNRB) being taxable at 40%. 

"Making a gift even days before death can bring the total estate below the £2m threshold, for the purposes of re-gaining the RNRB. Although important to note that the gift would still fall back into the estate for tax. Our advice is to first identify if there's likely to be a liability, and then if there is, consider which tools will be most appropriate in your situation. There's no one size fits all solution to this.”

Scott Gallacher, Director at Leicester-based Rowley Turton, worries that it is not even London families affected.

He added: “Even outside of the London bubble, we’re seeing hardworking families drifting over the £2 million IHT threshold without realising it — especially with pensions expected to be included from April 2027. 

"The tapering of the Residence Nil Rate Band above this level creates an effective 60% tax trap, one of the harshest in the tax system. With frozen allowances and rising property and pension values, many middle-class families are now choosing to spend it, gift it, or seek advice from independent financial advisers (IFAs) on how to minimise their potential IHT liabilities.”