Before we talk about how to avoid inheritance tax, we need to understand what the IHT problem is all about.

As discussed elsewhere, inheritance tax is payable on estates over £300,000 (at the time of writing), but transfers between a husband and wife are exempt.

The problem is that most people actually end up wasting this exemption.

Let's illustrate this with an example.

Between them, Mr and Mrs Jones own a house and other assets worth £500,000. Assuming they own everything 50:50, then each of them is worth £250,000 which is less than the current IHT threshold of £300,000.

So, at a quick glance, it might seem like they do not have an inheritance tax problem.

In theory, if they both died at the same time and each of them left their £250,000 to their children, then there is no IHT to pay. This is because each of them has an IHT free allowance of £300,000 and each of them has an estate worth less than that.

Of course, in reality, it is unlikely that Mr and Mrs Jones will die together. What's probably going to happen is that one of them (let's say Mr Jones) will die first and then Mrs Jones will die at a later date.

Let's assume for the moment that Mr Jones has not done any inheritance tax planning and so his will simply leaves everything to his wife or (if she is already dead) to his children.

So, Mr Jones dies and his £250,000 passes to his wife. There is no IHT to pay because a transfer to a spouse is exempt from inheritance tax. Mrs Jones now owns the full £500,000 (her original £250,000 plus the £250,000 she has now inherited from her husband) outright.

That means that when she dies a few years later and leaves everything to her children, she has an estate of more than £300,000 and so IHT has to be paid on the balance. In this example, the IHT payable amounts to 40% of £200,000 which is £80,000. (NB - for simplicity, this example assumes that the IHT threshold has not changed since Mr Jones died a few years earlier and so is still set at £300,000).

By leaving everything to his wife when he died, Mr Jones did not need to use his £300,000 inheritance tax exemption - the so-called nil-rate band. What would be nice is if Mrs Jones could therefore have approached the taxman when Mr Jones died and said "My husband just died and left everything to me, so he didn't use his nil-rate band. Please can you combine his unused allowance with mine when I die, so as I am able to leave up to £600,000 to my children without incurring an inheritance tax bill?"

But, unfortunately with the inheritance tax nil-rate band, it's a case of "use it or lose it". That's why Mrs Jones only gets to use her own £300,000 allowance when she dies and leaves everything to the children and that's why we said at the start of this article that most people end up wasting their inheritance tax allowance.

So, how could the Joneses have avoiding wasting Mr Jones's nil-rate band IHT allowance when he died?

Well, broadly speaking, there are two things they could have done. For either option to work, they would have had to first make sure that they owned their house as tenants-in-common rather than as joint tenants. More information on this can be found on our page about severing a joint tenancy.

The first option would have been for Mr Jones to leave his half of the £500,000 worth of assets to the children. That would have meant he was leaving £250,000 to his children which would have been free of IHT because it was less than the IHT threshold of £300,000.

By doing that, his nil-rate band would not have been wasted. There would have been no IHT payable when he died and, when Mrs Jones died a few years later and left her estate to the children, there would still have been no inheritance tax to pay as she would only have been leaving £250,000 as well.

The drawback is that throughout the time she was a widow, Mrs Jones would have been living in a house that was owned jointly by her and her children. This is not ideal, as it means her children could have tried to force her to sell the house if they had wanted to get their hands on the cash that was tied up in the property.

A much better alternative is to use something called a nil-rate band discretionary trust. With this method, Mr Jones would have left his £250,000 to a discretionary trust instead of to his children. Mrs Jones would have been able to have access to the trust fund during the rest of her life and then, when she died, the trust would have paid out to the children.

The children would therefore have inherited £250,000 from the trust and £250,000 from Mrs Jones and there would have been an inheritance tax saving of £80,000.

To find out more about this kind of inheritance tax planning, please see our article about avoiding inheritance tax with nil-rate band discretionary trusts, or click here to get some advice from a qualified inheritance tax planning consultant.