Last year, HMRC received more than £5.4bn in death duties. Inheritance tax was originally deemed to only apply to the rich, but now a much greater proportion of the population is affected. To maximise the transfer of family wealth through the generations, it’s important that you plan.
Inheritance tax (IHT) is essentially a transfer tax between individuals, trusts and family members. It captures all transfers of value not made on an arm’s-length basis. All transfers in excess of specified limits are therefore deemed taxable – even if made prior to death. In a world where we seemingly pay a tax on everything, IHT is one tax we can avoid with some expert planning. Intergenerational wealth – or rather the way in which we pass our assets through the family line – has never been more important. It’s important to ensure your loved ones receive their inheritance in an as tax-efficient way as possible.
Who does inheritance tax apply to?
Each of us is given a nil-rate band which is currently £325,000. If you give away your home to your children (including adopted, fostered or stepchildren) or grandchildren, this threshold can increase to £500,000. If you are married or in a civil partnership, your estate will pass IHT exempt to your spouse on your death if this is your wish. If you have left legacies to someone other than your spouse in your will, this will utilise your nil rate band (NRB). Your spouse will inherit all or any remaining NRB, depending on the provisions of your will. This means that their threshold can be as much as £1m.
The standard inheritance tax rate is 40% and is only charged on the part of your estate deemed to be above the threshold. Transfers between spouses on death are free of IHT, therefore estates will only pay the tax after the second person has passed away, depending on the provisions of their will. This additional threshold on property is known as the residential nil-rate band. However, this additional band is reduced for estates valued at more than £2m. This reduction is applied at a rate of £1 for every £2 over the £2m limit. So, for estates over £2.35m, the additional residential nil-rate band is lost.
So, when should you start planning?
This is, of course, a matter of choice. Different families will focus on IHT when it seems right for them to do so. As an adviser, I would always encourage that people get an understanding of what their liability is from an early age – even if they decide not to address it. For some families, dealing with IHT will be straight forward, but modern families can be complex.
It is not uncommon to see second marriages and additional children. This itself can present problems when dealing with the distribution of an estate, particularly when dependent children are involved and children with different parents. It is therefore always advisable to work with your financial planner and your solicitor to achieve a solution to protect all family members and to ensure your estate goes to the right people at the right time and in a tax-efficient manner.
When looking at IHT mitigation, I think it is always important to know your current objectives and long-term needs first, then address the tax implications afterwards.
Even if you don’t plan to conduct any IHT mitigation immediately, it is still worth calculating what your potential liability will be – and become aware of the potential solutions. I suggest you take the following steps.
1: Make a will and keep it updated
If you haven’t already done so it is vital that you make a will. A will forms a major part of your estate planning, as at the very least it will make sure that your estate is distributed in line with your wishes. If you do not make a will, your assets will be distributed according to intestacy rules and it may be liable to IHT that would be otherwise avoided.
2: Calculate the value of your estate
If you would normally qualify for the residential NRB but your combined estate is above £2.35m, is there any planning that can be done so that you do not lose this valuable additional band? This why it is important to know the value of your assets!
3: Know your reliefs and allowances
Many websites can provide guidance on what is allowed and are good resources. For example, gifting rules allow £3,000 to be gifted each year free of IHT, but smaller gifts of £250 per person each year are allowed too. For any gifts above this amount, you must survive for at least seven years until these gifts are deemed to have avoided any IHT. If you die in the period, IHT is payable on a reducing scale.
4: Consider using trusts
Previously, trusts have been effective tools to pass on assets and mitigate IHT. However, legislation changes have now bought further tax burdens upon trusts and they are not as attractive as they once were. However, in the right circumstances, they can offer some effective planning.
5: Look at protecting your inheritance liability
It is possible to take out a life assurance policy that can protect against your IHT liability. As long as this policy is written into trust, it will not form part of your estate – leaving your executors in a position to meet the IHT bill. These policies are usually ‘whole of life’ and payable on second death for spouses, as generally, IHT is only payable when both have passed. This may allow you to avoid having to ‘gift’ parts of your estate, but they can be expensive.
6: Give money to charity in your will
If you give 10% or more of your net estate to charity, this will effectively reduce the overall IHT on your estate from 40% down to 36%. For many families with excess wealth, this is an ideal way of reducing the tax burden and doing good as well.
7: Save into a pension plan
Most of us already have a pension plan via our employment and save towards our retirement. Pension funds are not included in the calculation of IHT so they can be an effective way to save and to keep assets outside of the estate. In some wealthy families, individuals do not need access to their pensions and so pass them onto future generations.
The downside can be losing access to your fund, as withdrawals are not permitted prior to age 55. Withdrawals above the pension commencement lump sum are taxable.
8: Set up a Family Investment Company (FIC)
FICs can also be used to assist in IHT planning and have become more popular in recent years, as rules surrounding trusts have changed. These can provide an excellent way of passing assets through the generations, as shareholders can be varied at any time. The downside is that they are taxed as a normal business under company law so large distributions, particularly in the early years, can be quite costly in the hands of the recipient. Successive governments may also change the rate of tax applicable and make them less attractive.
9: Invest into an AIM portfolio
AIM portfolios attract Business Property Relief (BPR) and, unlike a gift into a trust or to an individual, the assets are deemed to be ‘IHT proof’ after two years. The advantage of these portfolios is that the owner of the assets can recall them if needed in the future. You can also use your ISA allowance, which can help with any capital gains tax if a withdrawal is needed.
These portfolios are used predominantly by people in the latter stages of their life who take advantage of the shortened timescales involved. However, these types of investments carry a relatively high risk.
10: Spend all your money!
Spending any money above the nil-rate and residential nil-rate bands seem like the most obvious solution. However, this is simply not viable for most families, as we all need savings for unforeseen events including long-term care needs. However, just owning your own home can use up most of the available NRBs, so giving away all of your savings is not a good idea.
There are many different methods of completely mitigating or reducing IHT. However, lots of these avenues may result in you losing control and access to your money, this is not advisable, particularly in your younger days.
This is why it is always incredibly important to focus on what your needs are likely to be throughout your life as well as your family’s. As a rule, you should consider your own needs first before conducting any serious planning.
It is imperative that you work with a good financial adviser and/or solicitor to explore your different options. Some couples decide to do nothing in their younger years, or just start the beginnings of an effective IHT reduction strategy. In many cases, it is likely that a variety of methods may be used to help mitigate IHT over the years. The most important thing is to be aware of your current situation and the options open to you longer term.
By having an effective conversation with your financial planner, you will at least have the peace of mind of knowing your potential liability and the steps available to deal with it.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.
Inheritance tax and intergenerational wealth – know where you stand
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