Avoid being clobbered by IHT
So much for the Conservative's pre-election promise to raise the inheritance tax (IHT) limit to £1 million. The government's recent Budget held the nil-rate band, on which no tax is payable, at £325,000 per individual.
The government plans to hold it at this level until 2014-15. Those who'd hoped to be able to pass on a magic million, tax free, have been disappointed.
But hold on. Under the current rules, fewer people now pay IHT than at any time since records began in 1938. This is because, under rules introduced by the Labour government in 2007, the survivor in a relationship can claim the deceased spouse's unused IHT-free allowance, effectively allowing the surviving spouse to pass on £650,000 tax free.
This has transformed the IHT landscape, so that only around 12,000 households now pay death duties each year.
However, many people with estates larger than £325,000 will still need to arrange their affairs carefully to avoid paying more tax than they need to. The entire excess over the threshold is subject to tax at 40%, which works out at 27% for a £1 million estate.
Other people may need to organise their assets to avoid a forced sale of their homes and other assets, even family heirlooms, to pay their tax liability.
"The main problem is that people just do not think about death," says Leonie Kerswill, personal tax partner at PricewaterhouseCoopers. "But it's never too early to think about IHT planning. There are a lot of simple things people can do to reduce any liability and ensure they leave the maximum amount to their family and not the taxman."
The key principles of IHT are that the first £325,000 of someone's estate is is exempt from the tax, while transfers between spouses or a couple in a civil partnership are tax free during their lifetimes and on death.
This means it is no longer necessary for a married couple to split the family home between them so that they can each bequeath their half directly to their children - a widespread practice prior to 2007.
The new rule does not apply to unmarried partners, however. If the home of an unmarried couple is worth more than twice the nil IHT limit, tax may be due on their half when they die.
A spouse who has inherited everything can be caught out if they give something away on the wishes of the deceased. If you want your spouse to give an asset or even a favourite item to a relative or friend on your death, keep the agreement informal. If you formally give something away and you die within two years, the gift will be treated as if it was made from your estate.
There is one situation when leaving everything to your spouse may not be the best option, and that is when a widow or widower remarries.
If you are a widow, for example, it may be sensible for your new husband to leave everything to the children, so that on your death they would inherit the full allowance from your second husband and also your band, plus the IHT allowance from their own father.
The best way to reduce the value of your estate and with it the tax due on your death is to gift as much as you feel able to. Below we detail the areas and schemes you should consider to maximise your legacy.
CHARGEABLE LIFETIME TRANSFERS (CLTs)
These can help reduce your IHT bill. They are used to gift assets, but they are not exempt transfers. Instead of the full IHT rate of 40%, they attract an immediate lifetime IHT charge of 20%, or 25% if the donor pays. If the donor agrees to bear the IHT liability, the tax further reduces the value of the estate.
Furthermore, tax is only payable when the total amount of CLTs added to other CLTs made in the previous seven years exceeds the nil-rate band.
If, for example, the CLTs for the past seven years amounted to £375,000, the amount over and above £325,000 (£50,000) is taxed at 20% (£10,000).
Although anything you give away more than seven years before death is exempt, there is a key exception when you give something away but continue to use it.
If you gift your home, for example, but continue to live there. Such a present is called a gift with reservation of benefit, and it will count as yours when you die.
These reliefs are designed to ensure that family businesses do not have to be broken up when one member of the family dies. Unincorporated businesses are exempt from IHT, as is 50% of the property used in a business controlled by the donor or their partnership. Controlling shareholdings in quoted companies are also 50% exempt.
The government offers full exemption to investors' holdings in qualifying stocks listed on AIM, which is primarily a market for fledgling companies. Enterprise investment schemes are also exempt after you have held them for two years.
AGRICULTURAL PROPERTY RELIEF
A 50 or 100% exemption is available where the owner has occupied agricultural property for at least two years or where it has been owned for seven years while others have been farming it.
To qualify for 100% relief, the owner has to have the immediate right to vacant possession of the property or to obtain it within 24 months, or the property must be let on a tenancy that began on or after 1 September 1995. In all other cases, the rate of relief is 50%.
The taxation of forestry and woodland has always been fairly generous to encourage people to purchase woodland. Woodlands relief applies to the value of timber grown and allows IHT to be deferred until the timber is sold. The land the timber is grown on can usually gain agricultural property relief.
If a person's death is due to active service in the armed forces - even if death is delayed - the entire estate is exempt from IHT. The most famous exemption claim was made by the 4th Duke of Westminster who claimed his cancer was hastened by septicaemia in a stomach wound sustained fighting in France in 1944.
Where it is not possible for someone to reduce the size of their estate and IHT liability, life assurance plans can be taken out to provide cash to meet that liability.
This must be written in trust or it will simply increase the size of an estate further. Contributions to a life assurance plan will usually fall into the exemption for normal expenditure from income.
Any life policy that pays out on your death, whether it's a death-in-service benefit from your employer, it's attached to your pension or linked with your mortgage, will pay out money straight into your estate unless you make it written in trust.
Once it is written in trust, it will be paid into a trust on your death and that trust will be passed on to the beneficiaries rather than be paid directly to the beneficiaries as cash. For those who want to cover the IHT liability on a property, a joint life last survivor policy in trust can work well.
A range of trusts can be set up by a specialist tax adviser to help reduce IHT. For those with investments who want to make a gift yet control the destination of the benefits, a discretionary gift trust works well.
The donor must live for seven years to avoid tax, but trustees can keep control of the money, preventing beneficiaries from splurging on holidays or fast cars, for example, without entirely surrendering future access for regular withdrawals or irregular capital sums.?
The pre-Budget report at the end of 2009 declared HMRC's intention to limit two common IHT mitigation schemes involving trusts. Under one scheme, an individual was able to avoid IHT by purchasing a trust interest that had not previously fallen inside the scope of IHT, such as an excluded property trust interest. Such an interest will now form part of the purchaser's estate.
The second scheme involves trusts in which the settlor, or the settlor's spouse or civil partner, retains a future trust interest (a reversionary interest).
The draft legislation provides that there will be a transfer for IHT purposes when the future interest comes to an end and the person becomes entitled to an actual interest under the trust. If that future interest is given away before the person becomes entitled to an actual interest, it may be immediately subject to IHT.
Death benefits from pension plans are broadly exempt from IHT, but if they are passed on to the survivor from a couple they will form part of his or her estate.
Some will find it beneficial to put them in a spousal bypass trust, which rakes them outside the surviving spouse's taxable estate yet gives the survivor access via trustees.
The government has recently softened its stance on forcing people to buy an annuity with their pension savings at age 75. The prime objection to buying an annuity has always been that when the policyholder dies the money disappears.
From next April individuals will not have to buy an annuity. Instead, they can draw down an income directly from their pension savings. This will be capped at an annual limit to reduce the risk of someone running out of money and falling back on state benefits. Provision will be made for people who can prove they have secured a minimum income elsewhere.
On death, any unused funds will be hit by a recovery charge of around 55%, unless the assets are being used to provide a dependant's pension. This appears to assume that 25% of the pension savings were taken as a tax-free lump sum at retirement, so added together this equates to a 40% rate on the entire pre-retirement pension pot.
Pre-retirement pension funds are normally IHT free, but death duties may be applied if HMRC feels the pension has been used specifically to avoid them, rather than for pension planning.
A case between the personal representatives of Patricia Arnold (deceased) versus HMRC in February raises important issues where a member of a pension scheme or plan is able to draw their retirement benefits but chooses not to do so and then dies.
In such a case, where the death benefits are held in trust, HMRC could argue that the individual had deliberately failed to draw their retirement benefits to reduce the value of their estate and increase the value of another person's. In such circumstances, an IHT charge is levied on the value of the deceased member's retirement benefits immediately before their death.
Both individuals in any couple can make the following gifts:
• Small gifts of up to £3,000 per tax year, per donor. Any allowance not used up can be carried forward for one year.
• An unlimited number of small gifts of £250. These can be made to any number of different people.
• Gifts out of income, provided they do not affect the donor's standard of living and are seen to be part of the normal pattern of expenditure, rather than a deliberate running down of the estate. Regular gifts to help a child through university are common.
• Marriage gifts or gifts for couples entering into a civil partnership. Parents can give £5,000 to each of the happy couple, grandparents can give up to £2,500 each and everyone else can give £1,000.
• Charitable gifts. This can include gifts to charities and institutions for the public benefit, such as museums and art galleries, as well as political parties.
• Gifts for the maintenance of a dependant such as a spouse or former spouse. The gift could also be for the education of a child or to provide for a disabled relative.
Any gift to an individual, which is then referred to as a potentially exempt transfer, becomes exempt if the donor survives for seven years from the date of the gift. If you die within three years, tax will be due at 40%, but after three years a tapered rate of IHT, reducing by 20% each year, is payable.
If you are short of cash in your twilight years, an equity release plan will release some of the money tied up in your home and might also help reduce your tax liability. Equity release plans are not great value, but it is a personal choice that many more people are making.
According to Key Retirement Solutions figures, sales of equity release plans grew by 22% in the first half of 2010.
This article was originally published in Money Observer - Moneywise's sister publication - in September 2010
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
This is more usually a feature of car insurance but it can also crop up in contents, mobile phone and pet insurance policies. An excess is the amount of money you have to pay before the insurance company starts paying out. The excess makes up the first part of a claim, so if your excess is £100 and your claim is for £500, you would pay the first £100 and the insurer the remaining £400. Many online insures let you set your own excess, but the lower the excess, the more expensive the premium will be.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
Generally thought of as being interchangeable with insurance but isn’t. Assurance is cover for events that WILL happen but at an unspecified point in the future (such as retirement and death) and insurance covers events that MAY happen (such as fire, theft and accidents). Therefore you buy life assurance (you will die, but don’t know when) and car insurance (you may have an accident). Assurance policies are for a fixed term, with a fixed payout, and unlike life insurance have an investment aspect: as a life assurance policy increases in value, the bonuses attached to it build up. If you die during the fixed term, the policy pays out the sum assured. However, if you survive to the end of the policy, you then get the annual bonuses plus a terminal bonus.
A term to describe financial products or ‘plans’ that help older homeowners turn some of the value (equity) of their homes into cash – a lump sum, regular extra income, or sometimes both – and still live in the home. There are two main types of equity release: lifetime mortgages and home reversion plans (see separate entries for both). Whichever type you choose, you borrow money against the value of your property, on which interest is charged, and the loan is repaid when the house is sold after your death.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.