Many people aren't aware that if their estate is valued at over £325,000 (or £650,000 if you married or in a civil partnership) it will be subject to 40% inheritance tax (IHT). Director of Leicester based Finch Tax explains more about IHT and what you should consider to reduce your exposure and provide more for your beneficiaries.
What is IHT an issue and how can someone value their estate?
IHT is imposed on a deceased person at the rate of 40% on their taxable estate over their available nil rate bands and therefore this reduces what passes to the next generation and assets such as the family home may have to be sold to pay the tax.
A person’s estate for IHT purposes includes the following whether held in their own name or joint names (but if joint names only the value of their share is included):
a. Assets – bank accounts, investments, properties
b. Possessions – car, household items, jewellery, furniture
c. Lump sums received on death such as life insurance policies
d. Debts such as a mortgage, loans and credit cards can be deducted
e. Any non-exempt gifts made within seven years of death
f. Assets previously given away, but a benefit retained. For instance, the family home which had previously been given to the children, but the donor has continued to live there rent-free.
g. If a person is a beneficiary of a trust in which they have a qualifying life interest, their share of the trust assets.
Each person can have an estate worth up to £325,000 but any excess over this would be taxed to IHT at 40%.
There is now a Residence Nil Rate Band which provides extra relief for a person’s home (£150,000 for 2019/20) or a previous home if it is passed to children or grandchildren on death.
If a person who is married or in a civil partnership passes away but does not use their nil rate bands on death, then those nil rate bands will be available for their spouse or civil partner to use on their death.
If IHT is payable, then it is due by the end of the sixth month after the person’s death. If there is not enough cash in the estate to fund the tax payment, then the executors will need to sell the deceased’s assets or source a loan to pay the tax. Interest is charged by HMRC if the tax is paid late but it may be possible to pay tax in instalments on certain assets.
Utilise gifts and trusts
An effective way for a person to reduce their estate before death is to give away as much as possible before they die. But unfortunately, as the date of their demise is impossible to predict, it makes planning difficult.
If a person can give away cash or assets seven years before they pass away, then these will not be caught in their estate and tax charged at 40%.
However, a person needs to consider their needs and financial security for the rest of their life and therefore tax savings should never be at the expense of their wellbeing. Everyone is different. Some people would prefer to give it all away and rely on local authority funding to provide them with their care requirements. However, some would prefer to fund their own long-term care hoping to stay in control if residential care is required.
If giving assets away is appropriate, then it is important to consider whether capital gains tax would apply. This does not apply for cash but if say a property is given to a child or children directly or via a trust then it is likely that any profit made between the date of acquiring that property and the date of gift will be subject to capital gains tax. There are exemptions and potentially ways to defer paying the tax, but advice should be taken from a suitable professional.
Trusts are a effective tool to pass wealth down to the next generation. A person can give away an asset and after seven years it disappears from their estate. However, they can still control it and control who benefits from it assuming they appointed themselves a Trustee of the trust.
Since 2006, Trusts set up by a person in their lifetime do not form part of a beneficiary’s estate on death. But it should be noted that Trusts are subject to their own IHT regime with a maximum 6% IHT payable every ten years and on assets leaving the trust if the value of the trust exceeds the available nil rate band (max currently £325k).
As well as there being a cost to create a trust, there are likely to be ongoing professional fees required particularly if the assets in the trust produce income – such as an investment portfolio or rental property. Therefore, tax returns and accounts may be required. Trusts are a specialist area and can be complex and therefore advice should be taken from a suitably experienced person before proceeding.
Is the home a family seat or a tax millstone?
It’s both but for most it will be a tax millstone. The family home will often be the most valuable asset in a person’s estate and we are frequently asked if there are ways to mitigate IHT on the home while the client remains in residence. But over the years the government have put anti-avoidance measures in place make this difficult.
Home owners considering a tax mitigation arrangement should be wary of any risk to their continued occupation of the property if this becomes reliant on the consent of other family members. Therefore, any IHT planning involving the home should only be considered after alternative options for mitigating IHT have been explored.
The new residence nil rate band does help as it could wide out any IHT charge on low-value estates and therefore lifetime gifts may not be required.
Various strategies for the home have been used in the past and many of these have been far from straightforward and in most cases unsuccessful due to HMRC’s attention to this area.
Other methods of mitigating IHT (ie AIM stocks; insurance)
IHT relief - There are valuable IHT reliefs available to reduce a person’s estate, Business Property Relief and Agricultural Property Relief, and therefore some planning might involve structuring asset ownership to ensure tax efficient investments are made to obtain these reliefs wherever possible.
Gifts out of income exemption - If a person earns more than they spend then it would be advantageous to use the normal expenditure out of income exemption to make gifts either to trusts or individuals. Gifts that qualify will be exempt from the outset and the usual seven-year rule does not apply so the nil rate band on death is not eroded.
Discounted gift schemes are single premium investment bonds and therefore 5% of the initial premium paid can be withdrawn tax free each year for 20 years giving an ‘income’ for the person taking out the scheme.
These schemes are particularly efficient for inheritance tax purposes, because the value of what is given away is discounted to take account of the fact that the funds will not be released to the ultimate beneficiaries until the death of the person setting up the scheme and that he or she retains the right to annual withdrawals.
If the person survives for seven years after setting up the scheme, the value of the gift will fall out of his or her estate. If he/she does not survive for that period, the value of the discounted lifetime gift will have to be agreed with HMRC.
Life assurance written in trust – If a person has a life assurance policy such as a death in service policy then in the event of his or her death the proceeds of it usually form a significant lump sum. In the absence of any other arrangements this lump sum is added to your estate for IHT purposes. If this pushes the value of your estate above the tax-free band for IHT then this money will effectively be taxed at 40%.
A person can request that the policy is written into trust for their nominated beneficiaries. This is effectively a lifetime gift of the policy into trust and therefore should they survive seven years the life assurance policy would not form part of their estate. Assuming they are in good health when they made the gift the policy on transfer into trust should be of little value and therefore avoids an IHT charge when put into trust.
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