Inheritance Tax Planning
Inheritance Tax Planning
Always a popular subject over dinner parties… Inheritance tax is sometimes misunderstood by many with a lot of people believing they have an inheritance tax problem, but after looking at their allowances this is not the case. Inheritance Tax (IHT) stands as a significant financial consideration for individuals in the United Kingdom, impacting the transfer of assets from one generate to the next. Understanding the basics of this tax is crucial for those planning their estates and seeking to preserve family wealth.
What is Inheritance Tax?
Inheritance tax is a tax levied on the estate of the deceased person before it is distributed to their heirs. The tax is applicable to the value f the estate above a certain threshold, known as the “nil-rate band.” The current nil-rate band in the UK is £325,000 per individual, meaning a married couple has a combined nil-rate band of £650,000.
Nil-Rate Band and Additional Allowances:
- The nil-rate band applies to the value of an estate. If the estate is worth less than this threshold, no inheritance tax is payable.
- Spouses and civil partners can transfer any unused nil-rate band to each other, effectively doubling the threshold to £650,000.
- Additional allowances, such as the residential nil-rate band (RNRB), may be available for those leaving a property to direct descendants. The RNRB can provide an extra allowance of £175,000 per induvial on top of the standard nil-rate band. The RNRB can reduce to zero by £1 for every £2 an estate is worth over £2m.
Tax Rates:
- Inheritance tax is charged at a rate of 40% on the value of the estate above the nil-rate band.
- Assets passing to a spouse or civil partner and some other exempt beneficiaries are generally not subject to inheritance tax. Any amount left to a UK -registered charity can reduce the rate of IHT charge by 10% from 40%, down to 36%.
Planning Strategies:
So, from above we can see above an individual has a tax-free allowance of £500,000 on death and a married couple has £1m combined tax-free allowance. Both of these examples assume their estate does not exceed £2,000,000 and their property goes to their direct descendants (think children and grandchildren here).
Gifting
Here are some ways you’re able to gift money and have the funds outside of your estate instantly.
Annual Exemption - Each individual is able to gift £3,000 each tax-year. You’re also able to carry forward one year and gift last year’s allowance if it wasn’t used.
Wedding allowance – You are able to gift £5,000 to a child, £2,500 to a grandchild and £1,000 to another relative or friend for a wedding.
Small gift allowance – You’re able to give as many gifts up to £250 per person as you want each tax-year, as long as you have not used another allowance on the same person.
Gifting out of surplus income – If you have enough income to maintain your usual standard of living, you can make gifts from your surplus income. For example, regularly paying into your child’s saving account providing there is additional surplus income to do so.
Other options
While all of the above are good places to start, for some estates, this may not scratch the surface a different approach maybe needed. Some examples below:
Outright gift – You are able to make a gift to an individual and if you are to survive 7 years, the gift will leave your estate. Should you die before 7 years, the gift will remain in your estate and be taxed accordingly. It is important to mention the gift should not have a reservation as this would fail the 7-year rule.
Whole of Life policy – A Whole of Life insurance policy is a type of life insurance that provides coverage for the entire lifetime of the policyholder(s). Unlike term life insurance, which covers a specific term, whole of life policies do not have a fixed term and pay out a death benefit whenever the policyholder(s) pass away.
For Inheritance tax (IHT) purposes, the proceeds from the whole of life policy are typically exempt from IHT if the policy is written in trust. Placing the policy in trust means that the payouts does not form part of the policyholder(s) estate for tax purposes.
The main purpose of a whole of life policy for IHT is to match the sum assured as closely to your IHT tax bill as possible. This policy can work well if taken out early and you are in good health.
Discounted Gift Trust – A Discounted Gift Trust (DGT) is a financial planning tool used in estate planning. It involves an individual making a gift into a trust while retaining the right to receive a fixed income from the trust for a specified period. The gift is “discounted” because the value of the immediate gift is reduced, taking into account the income stream retained by the donor. This arrangement can have potential inheritance tax benefits, as the taxable value of the gift is lower due to the retained income. DGT’s are often used to pass on assets to beneficiaries while managing inheritance tax liabilities and providing the donor with a stream of income during their lifetime.
The discounted part of the trust is immediately outside of your estate and the part that is not discounted, will have a 7-year clock as mentioned above under outright gift.
Loan Trust – A Loan Trust is a type of trust used in financial planning, particularly for inheritance tax purposes. In this arrangement, an individual makes a loan to the trust, and the trust invests the funds. The loan typically carries an interest charge. The trust assets and any investment growth are outside of the individual’s estate for inheritance tax purposes because it’s a loan rather than a gift. The individual can potentially receive repayments of the loan and interest, providing them with an income stream while gradually reducing the value of their estate for tax purposes.
Discretionary Trust – A Discretionary Trust is a legal arrangement commonly used in the UK for Inheritance Tax Planning. In this trust, the settlor (the person creating the trust) transfers assets to the trust, and a group of chosen trustees holds these assets for the benefit of a class of potential beneficiaries. Unlike specific gifts, the trustees have discretion in deciding how and when to distribute the trust’s assets amount the beneficiaries.
For Inheritance Tax purposes, assets placed into a discretionary trust are generally subject to an immediate charge to inheritance tax, where they exceed the nil rate band, and this would be charged at the lifetime rate of 20%. However, there is usually no further tax when distributions are made to beneficiaries.
There is also the 7-year clock as mentioned above under outright gift to consider when gifting funds to a discretionary trust. Beware also if gifts have been made in the 7 years before the establishment of the trust, as this can extend the waiting period by up to 14 years.
Bare Trust – A Bare Trust, also known as a simple trust, is a straightforward legal arrangement used for inheritance tax purposes in the UK. In a Bare Trust, the beneficiary has an immediate and absolute right to both the capital and income of the trust. The Trustee’s role is essentially passive, as they hold legal title to the assets but have little discretion in managing or distributing them.
There is also the 7-year clock as mentioned above under outright gift to consider when gifting funds to a bare trust.
AIM Investments – AIM stands for Alternative Investment Markets (AIM) which is an alternative market to the London Stock Exchange. AIM is designed for smaller and growing companies, offering investors the opportunity to invest in dynamic, potentially high-growth businesses.
Regarding Inheritance Tax Planning, holding AIM-listed shares within a portfolio can offer certain tax advantages. AIM shares can qualify for Business Property Relief (BPR), a relief that can provide up to 100% exemption from inheritance tax after the shares have been held for 2 years.
The risk here of course is small, listed companies that carry high levels of volatility.
Pensions
Typically, your pension is outside of your estate for inheritance tax. If you were to die before age 75, it would pass to your beneficiaries free of tax and if you were to die after 75, it would pass to your beneficiaries subject to their rate of income tax but in both events, outside of your estate for inheritance tax. As pensions don’t form part of your estate, it’s a useful planning tool to leave funds inside of a pension and use cash assets if available to reduce the value of your estate and potential inheritance tax burden. Also, ensuring an expression of wish is up to date to ensure the funds are going to the right place is good planning.
Summary
Although this has probably been a long read (for those of you who made it to the end!), it has only provided brief details on the allowances and planning opportunities which may or may not be relevant to your personal circumstances. I would encourage you to discuss any Inheritance Tax Planning with us so we can help you with the right solution for you.
All information is based under current legislation and subject to change. This is intended as a guide and not information you should act upon without qualified advice. Publishing date 2nd January 2024.
