RegulationJul 22 2016

IHT and protection

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IHT and protection

When former chancellor George Osborne announced the creation of the main residence nil-rate band in his Summer Budget 2015, he fulfilled one of the Conservative party’s manifesto promises.

However, while some couples will be able to leave £1m without worrying about inheritance tax (IHT), complexities in the rules mean protection advice will still be important.

Under the rules, as well as the standard IHT nil-rate band of £325,000, individuals will receive an additional allowance that can be used to pass on their residence.

The nil-rate band is being phased in, starting at £100,000 in the 2017/18 tax year and rising in £25,000 increments to £175,000 in 2020/21. After this, it will increase in line with the Consumer Prices Index (CPI).This means that, in 2020/21, the effective IHT tax threshold for an individual will be £500,000.

Furthermore, as both bands are transferable between married couples and civil partners, it will be possible for the survivor to leave up to £1m IHT-free.

Terms and conditions

But, while £1m may be a nice, simple, round figure, there are plenty of catches that will mean that not everyone will benefit.

Ian Dyall, head of estate planning at Towry, explains, “The rules are overly complex. Although they will remove the need for IHT planning for some people, others will have to ensure their affairs are arranged appropriately, and some will not benefit at all from the new nil-rate band.”

Initially, the main residence nil-rate band will only apply to the home. Although this can include rental properties that the individual has lived in previously, a couple will need a property worth at least £350,000 if they die in 2020/21 to gain the maximum benefit.

As an example, take two married couples, both with joint estates worth £1m. One lives in a property worth £400,000, while the other property is worth £200,000.

The couple with the more expensive property will be able to take advantage of the full £350,000 main residence nil-rate band, thereby leaving their entire estate without an IHT liability.

Conversely, the couple in the lower value property will only be able to use £200,000 of the main residence nil-rate band to pass on their home. The couple’s standard nil-rate band of £650,000 can then be applied to the remaining £800,000 of their estate, leaving an IHT liability of £60,000 (40 per cent of £150,000).

Another potential catch is that the property must be left to direct descendants on death to qualify for the additional nil-rate band. As well as sons and daughters, these can be adopted, foster and stepchildren, and any of their descendants. However, those without children will not be able to benefit from the new legislation.

Taper tantrum

The main residence nil-rate band is also means-tested. If the net value of the estate exceeds £2m, the additional nil-rate band will be tapered away at the rate of £1 for every £2.

This means that an individual with an estate worth more than £2.35m in 2020/21, or a couple with an estate worth £2.7m or more, would see no benefit from the additional allowance.

Although the £2m threshold will increase with CPI from 2021/22, it is also important to note that the definition of “estate” is less generous when assessing eligibility for the main residence nil-rate band.

While an estate’s IHT liability is assessed after the deduction of any exemptions and reliefs, these are not deducted when assessing whether the taper should be applied.

This presents a number of planning opportunities, as Elaine Cruickshank, tax and trusts manager at Aegon, explains. “Couples may wish to look at reducing the estate on first death. What is possible will depend on the situation, but where a share of the home is passed to the children on first death, there could be issues around security of tenure. Advice is essential,” she says.

These rules could also lead to a resurgence in deathbed giving. As the potentially exempt transfer rules require the donor to live a further seven years for the gift to be outside of their estate, this is ineffective as a means of reducing an IHT liability.

However, the legislation does not count these gifts as part of the estate when calculating eligibility for the main residence nil-rate band.

Therefore someone with an estate worth £2.25m might consider giving away £300,000 to fall below the £2m threshold.

Although the gift would still be part of their estate for IHT purposes, it would mean they qualify for an additional £125,000 of main residence nil-rate band, which will save them £50,000 in IHT.

Advice focus

Although government figures suggest that the new nil-rate band will reduce the number of estates with an IHT liability in 2020/21 by around 40 per cent, it still estimates that 37,000 estates will face an IHT charge that tax year.

Chris McNab, manager of protection proposition at LV, says, “Many estates end up with an IHT liability that could have been avoided with some planning, and it will be no different with the new rules. These changes are a great opportunity for advisers to talk to their clients about IHT mitigation.”

A key step for advisers will be reviewing wills to ensure they enable the main residence nil-rate band to be used. As well as stipulating that property is left to children, where trusts are in place, it will be important that these are in line with the legislation.

Suitable trusts include a bare trust, immediate post-death interest trust and an age 18 to 25 trust. The standard choice, which is the discretionary trust, is not suitable.

Aegon’s Ms Cruickshank explains, “These create too wide a class of beneficiaries so the requirement to leave it to a child would not be met. It would be sensible to adjust these arrangements where possible.”

Unmarried couples and blended families will also require attention from a planning perspective. Carefully worded wills can help to ensure that clients take advantage of the new nil-rate band and their property is passed on in line with their wishes.

This type of planning may also necessitate couples owning their home as tenants in common to enable the main residence nil-rate band to be used on first death.

However, the extra tax break must be weighed up with the implications for the surviving partner when their home is partly owned by stepchildren.

Phased protection

There are also some more immediate issues to address. Peter Hamilton, head of retail propositions at Zurich Financial Services, says many clients are under the impression that they already have a £1m nil-rate band to protect their estate.

“The new nil-rate band is being phased in, so someone who perfectly fits the £1m estate scenario in 2020/2021 would still have an IHT liability in the next few years. This will reduce from £140,000 this tax year to £20,000 in 2019/20,” he explains.

There are several options to cover this liability. A series of one-year term assurance policies is a low-cost and transparent way to cover this reducing liability.

Similarly, where someone wishes to cover additional IHT liabilities, it may be appropriate to take out a whole of life plan and reduce the cover and premium as the nil-rate band increases.

Helping clients adjust their IHT plans to take advantage of the main residence nil-rate band will be a key part of many advisers’ activities over the next few years.

But, with this a common area for change, ensuring that plans are flexible will be essential.