Planning for Inheritance Tax
Are you ‘choosing’ to leave your hard-earned wealth to the taxman?
IHT is often referred to as an optional tax because you can plan to avoid paying it by legitimate means. It is important to note, we are not talking about tax evasion which is of course, illegal.
There are so many taxes we pay throughout our lives that planning to avoid at least one of them is a worthy task to undertake for the benefit of our heirs, so they can choose how their inheritance is ultimately taxed. IHT currently stands at 40% so, in the scheme of things, it is a pretty hefty tax.
The keyword that makes all the difference is “planning”. If no planning is done how can any IHT liability be mitigated except by accident or coincidence? There may be no IHT to pay because the estate in question does not have a liability once all the relevant reliefs, allowances and exemptions are applied but, that fact still needs to be verified by a point in time analysis.
Everybody has an IHT nil rate band of £325,000 before taxation is applied. In addition, each person has a main residence nil rate band of £175,000 for use when passing your main home onto your direct descendants. However, the main residence nil rate band is tapered down for estates valued over £2m.
1. Consider the basic building blocks of good IHT planning.
The main elements of good IHT planning are an up-to-date will plus any trusts and, where appropriate, using IHT exempt investments. There are many specialist investment companies offering these products and they can be very useful when used wisely. As always, getting professional regulated advice when considering regulated investment products is essential.
Additionally, there are some life insurance products that can be used to mitigate the effects of a large IHT bill. Equity release can also be used where there is a good case for releasing money tied up in your home though this is a highly regulated advice area which must be carried out by suitably qualified professionals.
One way to beat the taxman is to give away your wealth over a period of many years but again, careful planning is required to not be caught out by a miscalculation or other mistake by simply misunderstanding the rules. The rules for this are complicated because we need to consider more than just the ‘basic 7-year’ rule when multiple gifts are spread over several different years as is often the case.
You also need to consider which assets are jointly held and the fact that the rules of survivorship apply in this case. If you are married then jointly held assets pass to your spouse free of IHT however, this is not the case between those not married or not in a civil partnership.
Perhaps the law will catch up with the fact that a lot of families now choose not to marry but for now, the IHT rule as it stands, only caters for married/civil partnered couples. This can be particularly troublesome when dealing with the family home when one partner dies.
Another situation to be wary of is what is commonly referred to as blended families. Sometimes children can be accidentally disinherited, and this starts by a new spouse becoming the main beneficiary of their parent’s estate. Although, this is not an IHT problem per se, it does bear thinking about during the will & trust writing and overall planning process.
To commit all these important financial decisions, you are required to be of sound mind. Something referred to as having sufficient mental capacity. Sadly, old age takes away our mental capacity to do all the things we want to, so we need to have someone we trust looking after our financial affairs when we can’t.
This is done by registering a Lasting Power of Attorney for property and finance with the Office of the Public Guardian.
2. Consider diverting legacies gifted to you in a will.
I often hear stories of people being left a legacy by relation or as a mark of friendship but in the cold analytical world of taxation, this could add to an unwanted IHT liability. A better way might be to side-step the gift by ensuring someone else in need receives that gift. A process known as a deed of variation where you can reassign a gift left in a will to someone else.
You would be able to see your nearest and dearest enjoy the money whilst you are still alive. Also, the inherited money would be taxed only once rather than twice which would be the case if you accept the gift into your estate.
This can have the dual advantage of not having to adjust your own IHT planning and also benefitting those who you are already planning to gift to in your will. Imagine a grandchild of yours receiving enough money to be ready with a deposit on their first home with money you had reassigned to them which was originally left as a gift to you in a will.
3. Consider giving some income away if you have a surplus building up.
Another useful method of passing on wealth to loved ones is making gifts from regular surplus income for things such as education costs and fees and/or rent for example. The rule is that the money used must be from income (such as a pension) and that the amount gifted is surplus to your normal living expenses.
Once a regular recorded pattern of gifting is established that meets these conditions then they become exempt from IHT. There is no limit to how much you can give tax-free provided you can afford the payments as described here.
Gifting from surplus income is an underused method of mitigating IHT either because people are not aware of it or because they believe they do not have a surplus of income every month. Generally, people save their surplus incomes by default for a ‘rainy day’ or for potential care home costs.
Though, it is worth checking whether your bank balance is getting unnecessarily large! Forward-looking financial planning can help you work out how much money you need for the rest of your life so this process will help you identify your actual needs and therefore, what can be considered a surplus.
4. Consider gifts from savings – Annual allowances and special allowances.
You can give up to £250 to as many people you want every year, and one special person can receive up to £3,000 in one tax year from you. If you missed giving away £3,000 last tax year, this can be made in the current year thus up to £6,000 can be given away “tax-free” to a single individual.
There are also ‘IHT free’ gifts that can be made to celebrate a marriage. £5,000 to a child, £2,500 to a grandchild or great-grandchild and £1,000 to any other person. *
It is always a good idea to make a written note of all lifetime gifts made so that when it comes to calculating the IHT, all the lifetime gifts can be deducted to save on the final tax bill.
Gifts from savings can be made in addition to gifts from normal expenditure out of income to take maximum advantage of the exemptions and allowances.
* The figures published were correct at the time of writing
5. Consider Pensions. They are a great way of passing wealth down the generations.
A defined contribution pension is a very good way of passing on a legacy provided the contract allows it. Most modern pensions (post-Pension Freedoms 2015) allow any nominated beneficiary (not just family members) to inherit some or all the pension pot free of IHT. It may be taxed when the beneficiary takes it as income but that is a different form of tax!
Pensions are mostly trust arrangements so any money or benefits you have in them fall outside of your estate for IHT purposes. Defined benefit pensions such as Final Salary or Career-averaged pensions do not form part of your net worth balance because they are designed to pay out on a regular basis for life. There is no pot of money in this type of pension, unlike a defined contribution pension which is a pot of money.
If you do have one or more defined contribution pensions, then make sure you review the nominated beneficiaries on a regular basis and note that this is a separate task from nominating your beneficiaries in your will.
6. Consider gift or non-gift. When a gift is not a gift in the eyes of the taxman!
Gifts can go wrong! A recent report estimated that some 440 people made the mistake of falling foul of the ‘gifts with reservation of benefit’ rule in the 2018/2019 financial year. If you gift your home to your children for example and you carry on living there without paying a market-level rent then you have what is known as a reservation of benefit and therefore, the taxman disregards the gift for IHT purposes.
In this case, the value of the house at the time of death would be included in the total value of your estate for the IHT calculation. This could be a nasty shock for those expecting that the value would be as at the time of the gift or that they thought the gift would be totally disregarded.
The example here highlights the need to get professional advice. The true value of good advice is often the difference between what you pay for the advice and the cost had you not taken the advice.
7. Consider avoiding the need for costly probate work.
As we would expect, having everything planned and documented helps your executors carry out their duties in a timely and efficient manner. The taxman expects to be paid within 6 months of the date of death so knowing exactly what to put on the forms, without delay to calculate the bill, diminishes the possibility of missing the deadline.
If your executors do need to employ the services of a probate solicitor to help sort things out, then that could end up costing them additional legal fees which might have been reasonably avoided by completing the appropriate level of IHT planning.
Lastly, the money in an estate can be tied up in probate for much longer than 6 months especially if a property is involved. One way to ensure enough cash is available to pay for the bills and expenses of your heirs is to set up a life assurance policy that pays out on death into a trust and therefore, bypasses your estate and probate.
About the author:
Simon Humphrey is a Lifestyle Financial Planner. He is a Chartered Member of the Chartered Institute for Securities and Investments.
Simon has a passion for helping people from all walks of life do more with their money so they can give it a purpose and be proud of their achievements.
He is keen that people are intentional with their money and that the correct people receive their legacies and improve the world for our future generations.
Simon would love to hear from you about your IHT Planning questions. You can contact him with your questions by email at simon@managing.lifes.money
For general information please visit our website: Agile Life
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