Inheritance tax (IHT) has traditionally been seen as a tax only for the very wealthy. However, with a threshold of £325,000 for the current 2010/2011 tax year, the price of houses are still relatively high even after recent corrections. More and more people are finding themselves caught in the trap. This could lead to beneficiaries of estates paying significant tax bills which a little bit of planning, could help avoid.
This guide is designed to help you through the maze of IHT, outlining who needs to be concerned, how it works and also introduce some of the ways you can use to help mitigate its effects on your estate.
What is inheritance tax?
Inheritance tax is payable when someone transfers ownership of their assets on death, or indeed on certain transfers made during their lifetime. Each individual is entitled to a nil rate band, under which no inheritance tax is payable. For the current tax year the nil rate band is £325,000 for an individual.
Traditionally very few estates have exceeded this nil rate band. However, despite recent corrections, the house price boom has pushed more people into the IHT net. Alongside investments, savings, death in service benefit, foreign homes or less obvious assets such as paintings or cars, the rise in property prices has boosted the value of an average estate. Even after the housing market started to fall in 2007, the Treasury’s 2008/09 receipts from IHT payments were still up 20% on 2002/03 (Source: HMRC).
The tax rate, on death, for assets over the nil rate band is 40% and the tax becomes payable relatively quickly; it is due six months after the end of the month of death.
This doesn’t give those people dealing with the estate much time to, for example, sell a house, or liquidate other assets that are necessary to meet the tax liability. With that in mind, if you find that your estate now exceeds the HMRC limits, what options do you have?
Well, the starting point is to look at the various IHT exemptions that are in place.
What are the exemptions?
Although the Government closed many of the IHT loopholes in the 2006 budget, a number of exemptions and allowances do remain. As a general rule you should aim to maximise use of these exemptions and allowances if you wish to pass as much of your hard-earned cash onto your heirs as possible.
In addition to the £325,000 nil rate band available on each estate, transfers on death or during lifetime, between husband and wife or between civil partners are tax free. Since 9 October 2007, such legally recognised partners can also transfer any unused portion of the nil rate band of the first person to die to their own nil rate band so that, in effect, the surviving spouse has up to £650,000.
However, be careful, this rule does not apply to cohabiters or ‘common-law’ spouses.
The majority of other exemptions and allowances come about through distributing some of your wealth prior to death.
You can make a variety of gifts which are immediately outside of your estate for IHT purposes. Gifts of £3,000 or less are allowed annually without being liable for IHT – and if unused, this allowance can be carried forward for one year. You are also allowed gifts on consideration of marriage or civil partnership. The amounts vary according to your relationship to the bride and groom – at the moment, £5,000 is allowed from the parents, £2,500 from the grandparents and £1,000 by anyone else. Gifts to charities also fall outside inheritance tax.
There is also a gift exemption applying to ‘regular gifts out of income’. These gifts can be as much as you like, but they must form part of a ‘pattern of giving’ and HMRC must be satisfied that after the gift has been made, you are left with sufficient income to maintain your standard of living.
Assets transferred prior to death can also be termed ‘potentially exempt transfers’ (PETs) for IHT purposes. Potentially exempt, because, from the day you give them away, the tax due on death is subject to a tapering over seven years, starting at 100% of liability for the first three years then falling proportionally from 80% over the next four. If you survive the full seven years, the IHT liability on that asset is zero.
However, the attractiveness of a PET is lessened as this taper relief only applies to amounts in excess of the nil rate band. As there is no tax due on the first £325,000, then no taper relief can apply. Therefore, if the total amount of gifts made exceeds £325,000 and death occurs within those seven years, the full amount of the original gift will be added back in to your estate and tax will be calculated on the total; as if you never gave that amount away. Having said that, if you do survive seven years, then that amount is considered as having left your estate and you therefore get the chance to benefit from the nil rate band allowance a second time.
There is an important restriction on PETs called a ‘gift with reservation of benefit’.
The principle is that if you continue to enjoy the benefit of an asset the transfer is entirely ineffective for inheritance tax purposes. This is in place to stop parents, for example, transferring their homes to their children and continuing to live in them. In order for such a transfer to be potentially exempt, a full market rent would have to be paid to the children after transfer.
Practical steps to take
Step One – the basics
Making a will is vital. If you die ‘intestate’, i.e. without a will, your estate will be divided up according to the rules of intestacy.
This is particularly important if you are not married, because you would be unlikely to inherit a ‘common law’ partner’s money, or even their share of your house.
For example, under the laws of England & Wales (the Administration of Estate Act 1925) your legal spouse or civil partner receives £250,000, plus personal chattels and a life interest in half the remainder of the estate and your children will get the balance at 18. If you have no children, £450,000 plus personal chattels and a life interest in half of the remainder of your estate passes to your spouse and the remainder to your parents If you have no spouse and no children, it will pass to your parents or then your siblings. If you have no legally recognised family, it goes straight to the Crown.
Note: In Northern Ireland, the intestacy rules are similar to these, however, in Scotland, the rules are quite different. Here, the intestacy laws are governed by the Succession (Scotland) Act 1964 which makes the situation a little more complicated. Please check with your solicitor or adviser to understand how the laws apply in your location.
In short, make a Will, it is easy to do, relatively cheap and means that you will avoid confusion on your death and it will allow your assets to be distributed as per your wishes.
Step Two – use your allowances
The basic allowances available have already been briefly outlined. Considering how you can use these in advance will help you manage the assets and any cash flow associated with a ‘pattern of giving’. In addition, if you can start giving away some of your assets as PETs when you are still in robust health and likely to live another seven years, this will save you worry nearer the time.
Step Three – using trusts
Trusts have long been seen as an easy way to brush off an inheritance tax liability. If this were ever the case, it certainly isn’t after the 2006 Budget. This closed down many of the tax planning opportunities for investors. Trusts can be complex and it is important that you take the advice from a suitably qualified adviser before you enter into such an arrangement.
Step Four – consider life assurance
Whilst no ‘saving’ on HT is made using a life assurance policy it can be a useful way to accumulate enough money to pay your inheritance tax bill. When placed in trust and with premiums funded from regular income as part of a ‘pattern of giving’, this is also free from inheritance tax – ie: you do not create an additional IHT burden because the trust keeps that lump sum payment out of your estate.
It is generally relatively simple to set up a life assurance arrangement. Take a married couple, both aged 65 and in good health. The first step is to calculate the IHT liability, for the purposes of the example let’s say this is £150,000, the couple take out a Whole of Life (WOL) policy with a sum assured of £150,000. The policy is written on a joint life second death basis as the IHT liability will not become payable until the 2nd death. The premium for such a policy would be based on the age, health and smoking status of the lives assured, however the cost is often less than anticipated.,. The premium would be guaranteed to remain unchanged for 10 years, after which time it would be reviewed. Importantly, the policy can never be re underwritten, meaning medical evidence, once the plan has been accepted, will never be requested again.
For those people with an IHT liability, who do not wish to give assets away or have no liquid assets a WOL policy can be a very attractive to the problem of IHT.
Step Five – Consider how your investments are arranged
There are a number of investments that are helpful in reducing IHT; however care should be taken not to let the tax tail wag the investment dog. The investment must be right for you, any additional IHT benefits are a bonus.
One option is to use a Discounted Gift Plan. These are usually investment bonds wrapped in a trust, designed to minimise, although not eliminate, IHT liabilities. You invest a lump sum and then take up to 5% of the capital out tax free each year. At the point at which you put money into the plan, a designated discount rate taking into account how long you are likely to live is calculated, how many years the 5% is likely to be paid out and therefore how much of the trust is ‘yours’ and forms part of your estate. These schemes do depend on having disposable cash, a need for income and a reasonable expectation of surviving the full seven years.
Shares that qualify for Business Property Relief (BPR) also can have an IHT benefit providing that the shares are held for two years. Most shares in privately owned businesses will qualify for BPR as will some portfolios of shares listed on AIM (the Alternative Investment Market). Shares listed on AIM have historically been more volatile and carry a high degree of risk. Over recent years there has been significant innovation from product providers to try and get the best of both worlds i.e. lower investment risk whilst retaining the IHT benefits. This innovation has paid off to a certain degree however investments of this nature carry a high degree of risk and must be considered carefully before they are entered into.
Over the past few years we have also seen the development of investments into woodland which may qualify for preferential IHT tax treatment. Again, this is a specialist investment and care should be taken to ensure that it is right for you.
Inheritance tax is perhaps not quite the ‘voluntary’ tax it was once considered. However, careful planning could reduce your estate’s liability significantly.
There are some relatively painless ways of reducing the liability and it’s never too early to start.