This year we’re set to hand over more than £2 billion in inheritance tax (IHT), according to research by professional advice website unbiased.co.uk. But with some careful IHT planning you can save you and your family from falling into this trap.
IHT is charged at 40% on anything in your estate above the nil-rate band (£325,000 in 20010/11). On an estate worth £450,000, this means an IHT bill of £50,000.
And as your estate comprises everything you own – including your home, savings, investments and your share of any jointly owned assets – you don’t have to be particularly wealthy to exceed the nil-rate band.
There has been some let-up for married couples and civil partners since October 2007. The introduction of the transferable nil-rate band (see below) means that any unused nil-rate band can be transferred to the surviving spouse, potentially doubling the exemption when they die.
Give it away
However, there’s still a chance you’ll be facing an IHT liability. A bit of forward planning can reduce this possibility. “The main way to reduce an estate is to give it away,” says Mike Warburton, senior tax partner at Grant Thornton. “If you live for seven years after making a gift, as long as you don’t reserve any right to it, it will be outside your estate for IHT purposes.”
The other important thing to remember with gifts is that, although they take seven years to exit your estate, any growth is immediately outside your estate. This is particularly beneficial at the moment with shares and property prices being so low.
As well as gifts, known as potentially exempt transfers or PETs, there are a number of exemptions you can use. These are immediately outside your estate and include an annual gift of up to £3,000; as many gifts of up to £250 a year as you like; and gifts upon marriage, which vary in size from £1,000 to £5,000, depending on your relationship to the bride or groom.
Another exemption commonly overlooked is regular gifts out of income. “There’s no limit on the amount you can give away as long as it’s regular, out of your income and it doesn’t affect your standard of living,” explains Warburton, adding that, if you use this exemption, it’s essential to document it fully.
As an example, he uses a woman in her eighties who starts to receive a pension income of around £20,000 a year when her husband dies. This is surplus to her requirements so she gifts it to her grandchildren to help with their school fees. She lives for a further five years, during which time she takes a total of £100,000 out of her estate, potentially avoiding £40,000 (40% of £100,000) on her IHT bill.
Look into trusts
It’s not always wise to give the assets away though, despite the IHT savings. This might be the case when you’re giving something to a teenager with a party lifestyle or to a son or daughter whose marriage is on the rocks and who is therefore likely to have to share assets in a divorce settlement.
In these cases, you might want to consider setting up a trust. “There are a number of trust schemes you can use to improve your IHT situation but still retain some control over the assets,” says Bob Perkins, technical manager at independent financial advisers Origen.
Just as with gifts, you’ll need to wait seven years before the asset is outside your estate. But, as the trustees (the holders of the trust, who could also be the beneficiaries) have the power to alter how the trust assets are distributed, there’s more control. Additionally, depending on the type of trust arrangement used, you can set it up to provide you with an income.
The most common forms are offered by life companies and include discretionary gift trusts, where the trustees can alter how the assets are distributed; loan trusts, where the growth is immediately outside your estate; and discounted gift trusts, where part of your investment, depending on your age, sex and health, is immediately outside your estate.
“But you need to take advice if you’re considering a trust as they are very complicated. They all operate differently so it’s important to have the one that’s right for your circumstances, otherwise you could find yourself worse off,” Perkins says.
Nil-rate band planning might also be worth considering to shift assets out of your estate.
Although the introduction of the transferable nil-rate band has made this less popular, it enables assets worth up to the nil-rate band at the time of death to go to beneficiaries without popping up in the surviving spouse’s estate. And, by putting them in trust, transfer to the beneficiary doesn’t have to happen until after the second death.
Bob Fraser, senior wealth adviser at Towry Law, explains why you might want to consider it: “The nil-rate band increases at the government’s discretion and typically it’s only an inflationary increase. Therefore, if you have assets that are likely to grow at a faster rate you might want to consider nil-rate band planning, which values them as at the time of the first death.”
With shares and property prices currently at a low, their future growth could well exceed the increase in the nil-rate band. “If you hold your home as ‘tenants in common’ rather than joint tenants, you can use this form of planning to shift half of it out of the surviving spouse’s estate,” adds Fraser.
There are other instances where nil-rate band planning might be worth considering too. Bob Bullamore, trustee services executive at Killik & Co, explains: “Nil-rate band trusts take the money out of the surviving spouse’s estate and can be useful for avoiding part of the estate being swallowed up in nursing home fees in old age.”
Although married couples and civil partners can use the transferable nil-rate band or nil-rate band planning to soak up some of the value of a property, the home is problematic from an IHT planning perspective.
“It’s one of the most difficult aspects, especially if you want to carry on living in your home,” says Warburton. “If you give it to your children but carry on living in it, you’re ‘reserving a benefit’, so it will never leave your estate. On top of this, your children could end up paying capital gains tax if it’s not their main residence, so they will end up in a worse position.”
There are ways to avoid this. If you give, or sell, the property to your children then pay a market rent on it, it will be outside your estate after seven years. The downside is that the rent is income in your children’s hands and will be taxed accordingly.
But Warburton explains one workable solution: “If the child lives in the house with their parent then the parent can give half the house to them. As long as they share the running costs then HM Revenue & Customs will accept that the parent only owns half the property.”
Where these options aren’t feasible, equity release is another way to reduce the value of your estate. By taking out a mortgage against your home, you create a debt on the estate. Then, providing you spend the money you raised, or give it away, you will reduce the value of your estate.
If you’ve got spare cash, you could make investments that qualify for IHT exemptions. To encourage investment in small UK companies, and to make it easier for family businesses to pass down through the generations, business property relief was introduced. With this, if you hold a qualifying share then, after two years and providing it continues to qualify, it will be exempt from IHT.
Many Alternative Investment Market shares qualify for business property relief, excluding those in companies involved in finance, banking and letting property. Additionally you can gain the relief by investing in an Enterprise Investment Scheme. However, while the IHT relief is generous, the risks can be high.
Life insurance is another option, with a whole-of-life policy guaranteeing that as long as you pay the premiums, however long you live it will pay out the sum assured. “Life insurance can provide for all or part of the IHT liability,” says Bullamore. “But arrange for it to be paid to the beneficiaries and not into your estate or it will add to the IHT problem.”
Whichever planning tools you use to reduce IHT liability, Bullamore has the following advice: “It’s essential to obtain good professional advice, especially where you’re giving away or redirecting funds. This will help you avoid making your, or your spouse’s, financial situation more vulnerable.”