The spectre of the EU referendum has cast some uncertainty over markets in recent weeks, and it’s still too early to tell which way this will go. Regardless of the outcome, one economic certainty is that the UK tax system will remain alive and well. One politically sensitive aspect of this system is Inheritance Tax (IHT), which is a popular discussion topic amongst clients.
The Prime Minister himself recently found himself caught in a Panamanian tax storm. Whilst the media got a little over-excited about the whole affair, the arrangements made by his father were in fact legitimate and Cameron has paid all personal taxes due. His handling of the matter did him no favours and it was ironic to see Cameron in this particular spotlight given the government’s recent hard line on tax evasion and avoidance.
There are a number of creative Inheritance Tax mitigation schemes out there, but I personally prefer black and white, as opposed to grey, when it comes to advising clients on this matter…
Most people prefer solutions that are tried and tested, easy to understand and rubber-stamped by HMRC. To my knowledge, there is no single tax solution that will wipe out an IHT bill in its entirety. In my opinion, making a serious dent in the liability should be the primary aim and this usually requires a combination of solutions over time.
Below is a very basic outline of the mainstream estate planning solutions I believe are the most effective in reducing IHT on an individual’s estate.
Every individual has a Nil Rate Band (currently £325,000), which is the maximum amount they can pass over tax-free on death. For married couples, this can be rolled over to the surviving partner, which effectively gives the survivor a Nil Rate Band of £650,000.
Any assets (property, savings, investment, etc) above the Nil Rate Band are chargeable at a rate of 40%. For example, if my estate is worth £1m and I have a Nil Rate band of £325,000, the remaining £675,000 will be charged at 40%. This would result in an IHT bill of £270,000 on my estate.
This is a very simple example but IHT can get very complex, so it’s a good idea to take advice.
1. Outright Gifts
Making gifts is one way to reduce the value of your estate and consequently the IHT liability.
Each tax year, you can make a capital gift of £3,000 to one person as well as £250 to any number of different people and these will be outside of your estate immediately. In addition to this, you’re permitted to make other types of gifts e.g. in the event of a child/grandchild’s marriage, political/charitable contributions, etc.
Any gifts over and above these modest exemptions are consideredPotentially Exempt Transfers (PETs). You need to live a full 7 years for these to be outside of your estate, otherwise they are simply added back in some proportion and taxed accordingly.
- Simple and no-cost.
- You get to see your beneficiaries enjoy the money in your lifetime.
- The assets will be outside of your estate if you survive seven years.
- Allowable exemptions are small, so make very little difference to the liability.
- PETs take seven years to become tax-free – some may see this as a long time to wait e.g. poor health, elderly.
- You have no control over the beneficiaries, they can spend the money however they choose to.
2. Gifts into Trust
Making a gift into a trust can be similar to a PET in that you may need to survive seven years for it to be fully tax-free. The key difference is that you aren’t simply handing over valuable assets directly to your beneficiaries; placing these in a trust allows you to retain a say over the way the money is invested, distributed and even used.
Some people perceive trusts to be complex and expensive to set-up and maintain. While it’s true there are a number of different types of trusts available, in my experience this can be kept simple and cost-effective particularly if the objectives themselves are fairly straight-forward.
- Allows you to retain control over how the asset is invested, who benefits and when.
- Assets are distributed more quickly than a will on death.
- Certain trusts benefit from an immediate IHT saving at the outset and be structured to pay you an ongoing income.
- With many trusts, you give up your personal right to the money or asset.
- No matter how simple or complex the trust, it’s best to take advice which will involve some cost.
- It still takes seven years for the gift to be completely outside of your estate in many cases.
3. Insuring the tax liability
A life insurance policy is an unlikely but very effective way to immediately reduce your IHT liability. ‘Whole of life’ cover will pay out a set sum of capital whenever the policyholder dies and this is then used to pay some or all of the tax liability.
Using the earlier example, the IHT liability on my estate is £270,000 and I want to reduce this by £100,000 immediately. Let’s say the monthly premium for a whole of life policy of £100,000 is £75 per month – provided I pay this premium for the rest of my life, the policy is guaranteed to pay out this amount. The policy is written in trust to ensure the benefit goes straight to the beneficiaries rather than to my estate where it would become taxable.
- Very simple arrangement and the sum assured can be increased in future.
- No assets need to be given away.
- IHT liability reduced immediately.
- Policies are subject to medical underwriting – not suitable for those in poor health or advanced age.
- Premiums are payable for life – long-term affordability is required.
- If you live an unusually long time, you may end up paying in more than the policy pays out.
4. Specialist Investments
Conventional stocks and shares ISAs are a popular way of investing tax efficiently (income and capital gains tax-free) but are not IHT-free, so will still make up part of a person’s estate on death.
There are, however, other types of investments that can become IHT-free after just two years of ownership, as they qualify for a specific tax relief known as Business Property Relief (BPR). These are typically shares in unquoted companies or those listed on the Alternative Investment Market (AIM). In fact, investors can now hold AIM shares in their ISA meaning they’re income, capital gains and IHT-free.
Provided the qualifying investments have been owned for 2 years and are held at the date of death, the invested capital is outside of your estate for IHT.
- You make investments in your own name (no gifts/trusts involved) and you retain personal access to the capital.
- IHT-free status is achieved much quicker than making PETs (two years instead of seven).
- More providers have entered this market in recent years giving more choice to investors.
- A professionally managed portfolio of BPR-qualifying investments can be accessed with as little as £10,000.
- Cash/stocks & share ISAs can be transferred into AIM ISAs for optimum tax efficiency.
- Investing in smaller companies carries greater risk than many mainstream investment funds. The portfolio can be more volatile and the risk of permanent capital loss is higher.
- Shares in smaller companies can be more difficult to trade, as there are fewer buyers. This means it may take longer to realise shares in your investment.
The pensions landscape has shifted significantly in the last couple of years. One major change to legislation means that pension funds are now no longer subject to any death taxes. This isn’t to say the fund will be completely tax-free on distribution – it depends on the person’s age at death, how the benefits are paid out and the income tax position of the beneficiary – but the important point is there is no automatic charge on death.
This now means that pensions can be passed down the generations more efficiently, much like a trust fund.
- No immediate death tax.
- Beneficiaries can be nominated and future generations can benefit.
- Investments within the pension fund remain income and capital gains tax-free.
- You may need to use the entire fund for your retirement and have little or nothing left to pass on.
- If your beneficiaries take the whole pension in one go, they may suffer a high income tax charge (depending on the size of the fund and their personal rate of income tax).
Choosing the right solutions for you very much depends on your circumstances and what you’re ultimately trying to achieve. As mentioned earlier, it’s best to take professional advice on this matter – most IFAs, solicitors and accountants can all offer practical solutions.
Feel free to get in touch if you’d like to explore your options in greater depth.
Thanks for reading.