Benjamin Franklin said: “Nothing is certain but death and taxes”. Whilst no-one has discovered the secret to the elixir of life, when it comes to taxes, a great deal can be done to mitigate their financial impact, particularly with regard to inheritance tax. Are you one of those professionals who are too busy to look after their own finances? This could end up being a costly oversight for your family.
There is rarely a bad time to take a close look at your financial planning with an expert and a key aspect of your financial plan is likely to involve estate planning. Even though increasing numbers of people are living until their 90s, we also never know when a catastrophe might strike.
As with all planning, attending to the basics is a great starting point. Making a will to ensure that your money goes to the people you would like to benefit rather than relying on the rules of intestacy is a must. Don’t forget the “living will” with a Lasting Power of Attorney in case of incapacity. If you feel inclined, tie the knot! Being married secures many benefits with a transferrable nil rate band and inheritance tax only payable on the second death.
Spend, spend, spend!
This might seem an unlikely suggestion from a wealth planner, but a great way of avoiding inheritance tax is to spend your money. I’ve experienced tremendous satisfaction over the years from providing my clients with the confidence to do just that.
Whether spending money on yourself or on you and your family, it doesn’t really matter. It is always best to spend 100% of some element of your savings during your lifetime than to leave your beneficiaries to spend 60% of it when you are gone, with HMRC taking the balance of 40%.
Gifts and exemptions
There’s no inheritance tax to pay on gifts between spouses or civil partners. You can give them as much as you like during your lifetime if they live in the UK permanently.
There are also many other small gift exemptions that may be taken advantage of. I will refrain from listing these verbatim, as there are many more issues I would like to cover. In any event they can be found quite easily at www.gov.uk/inheritance-tax/gifts
Large gifts to those other than a spouse can also be made without limit, although it must be borne in mind that these are only potentially exempt transfers of wealth (PET). A PET is only exempt if the donor survives for seven years after the gift has been made.
A word of warning here….do keep records. It is far easier and saves so much time for the person who is clearing up your estate if proper records have been kept. Notes of dates and amounts or a letter to a recipient detailing the gift – or series of gifts – should assist greatly.
Not everyone is in a position to make substantial gifts and neither might they have readily realisable assets with which to go on a spending spree. However, the recent growth in property prices will mean that many people will still have a potential IHT liability. If this is a concern then the liability can simply be insured. Married couples or those in a civil partnership could simply assess the potential liability and set up a “joint life second death” insurance policy to cover the tax due. This doesn’t remove the tax liability, but merely provides a means of paying for it.
The policy is written under trust and the proceeds of the policy are, therefore, outside of the estate for IHT purposes. The premiums would generally be classed as regular gifts out of surplus income and cover is relatively inexpensive.
For those not yet ready to undertake significant gifting or significant estate planning but still want to make provision for that liability, this is really effective.
Gifting to trusts is another established way of reducing inheritance tax. Here you lose the future use of the assets personally, but it is a great way of providing for future generations, particularly if they are of an age when you don’t want to make an outright gift or are vulnerable. This is becoming increasing relevant for the funding of the costs and fees associated with university education.
For those who can afford to make large gifts but want to retain control of future distributions and the future investment strategy, then acting as a trustee can facilitate this quite easily.
If you use a discretionary trust, each individual is limited to a gift of £325,000 (an amount up to the nil rate IHT band) in any seven-year period. Gifts to a discretionary of larger sums are likely to incur a tax charge, so are probably best avoided. You can set up a trust with a wide range of beneficiaries and decide later to whom you wish to give the money.
This is a slight over-simplification of the use of trusts, as there are some vehicles that do provide for some limited access to the donor, but there is not enough space in this article to expand on that to any great degree. An experienced financial planner will be of great help if you want to explore this further.
Moving up the scale of complexity and risk now….
Business Relief (formerly Business Property Relief) was introduced in the 1976 Finance Act essentially to enable a family business to survive and be passed on as a trading entity, without a liability to inheritance tax. It is relatively straightforward in its application, as the exemption to IHT is granted once qualifying shares in what are unlisted trading companies, have been owned for two years.
In 2013 the UK Government extended the scope of the legislation to enable shares listed on the Alternative Investment Market (AIM) to be held in ISAs. Many investors like to cling on to their ISAs because they have such good tax privileges, but if you retain them indefinitely there comes a point where the ISA just stores up a potential IHT tax charge. A switch to an ISA investing in AIM shares could solve that problem for you – after two years.
A portfolio of shares listed on AIM is likely to be more volatile than a traditional equity-based ISA and there are significant risks to capital with such an investment, so do take advice before making this switch. However, the potential volatility should be considered alongside the certainty of a 40% loss to inheritance tax.
AIM portfolios can also be accessed outside of an ISA. But be wary of capital gains tax constraints if you are restructuring other investment portfolios.
Business Relief is also available for other trading companies which, for instance, specialise in secured lending for leasing and power generation. They are not designed to provide huge returns, as they are focusing on capital preservation. However, they do qualify for Business Relief after holding for two years and so, at that stage, are exempt from inheritance tax.
Of course, again, these investments do carry risks, but if you don’t do something to help mitigate inheritance tax, your estate could face an unwelcome tax charge on death.
Finally, pensions are really an efficient way of passing money to the next generation and are generally exempt from IHT. So efficient are they, that we often find ourselves recommending that they are the first things to be funded and the last to be drawn upon. The “Pension Freedom” legislation introduced in 2015 was largely responsible for this.
However, Lifetime Allowance considerations and Annual Allowance constraints need careful management and often restrict what can be done for higher earners and those with large pension pots. However, do make sure you have completed a nomination form because the pension providers will want to know to whom to pay the pension benefits upon death and you can’t rely on your will to determine this.
Furthermore, whilst the legislation has introduced many new flexibilities, individual pension schemes have not always had their rules updated, so it is worthwhile examining all your existing schemes to see what the position is.
To provide the aforementioned confidence, you must have a financial plan. In this regard, a long-term cash flow analysis is essential.
Our planning-led approach involves working closely with clients to model their finances over the long term. This is their plan and not ours. So, we analyse their income and expenditure, their assets and liabilities, potential changes in lifestyle, and try then to take into account all the goals they might have for themselves and their families.
What individuals do during their lifetime is by far and away the most important element of this planning, but a bi-product of this is that we can also look at whether there is a potential liability for inheritance tax.
It is essential for a wealth planner to assess what can be safely given away directly or put into trust. A planner will optimise clients’ financial affairs and help to ensure they are in a better financial position during their lifetime and that as much of their asset base is preserved for future generations.
I can’t hope to cover off all the simple IHT mitigation tactics in a short article like this but hope I have at least provided some food for thought.
Don’t try DIY
Estate planning is not really suitable for a DIY approach – even by barristers and other professionals. A visit to an independent wealth planner now could really pay dividends in the years to come.
by Tim Clay, Wealth Planner, Succession Group