The government has now launched a review to simplify the IHT regime and make it fit for purpose, and protection can help ease the tax burden for younger generations.
The review, which is being undertaken by the Office of Tax Simplification (OTS), will look at a number of different elements of the IHT regime. As well as administrative issues such as the process of submitting returns and paying any tax due, it will also assess the rules around estate planning and whether these distort taxpayers’ investment and financial planning decisions.
Opportunities for simplification
The current rules certainly offer plenty of opportunities for simplification. As well as complexities around the different planning devices, recent changes have created further layers of complication.
A good example is the residence nil-rate band (RNRB), which came into effect in April 2017. This gives individuals an additional nil-rate band (£125,000 in 2018-19) when passing on the family home to direct descendants. Increasing each year, this will reach £175,000 in 2020, enabling a married couple to pass on an estate worth £1m without incurring IHT.
Although the RNRB enabled the Conservative party to tick off its manifesto pledge of a £1m inheritance tax allowance, it did little to make planning straightforward. This was demonstrated by a survey conducted by Old Mutual Wealth ahead of its introduction, which found that 70 per cent of people did not understand how it worked.
“The rules are complex but also incredibly restrictive, as you can only use it when leaving your home to a direct descendant,” explains Rachael Griffin, tax and financial planning expert at Old Mutual Wealth. “This does not sit comfortably with today’s society where blended families are common, nor is it aligned with the concept of testamentary freedom, which is in place in England and Wales.”
Modernising the rules
As well as making the rules easier to understand, the review will also offer an opportunity to modernise some of them. As a bare minimum, Ms Griffin would like to see some of the IHT exemptions brought up to date. For example, the annual gifting allowance of £3,000 has remained unchanged since 1981. If it had kept pace with inflation, it would have increased to £10,932 in 2017.
“Reports on intergenerational wealth show that this is largely held by the older generation,” she adds. “With allowances stuck in the 1980s, their hands are tied when it comes to passing this wealth on tax efficiently to the younger generations.”
Another change that many would like to see is an equalisation of the rules between married and non-married couples. Currently, an IHT exemption only exists where assets are left to a surviving spouse or civil partner, leaving an unmarried partner potentially facing an IHT bill on assets they may have shared for many years with the deceased. Under the current rules, marriage is the only way to avoid this IHT charge, as comedian Ken Dodd demonstrated when he secretly married his partner of 40 years a couple of days before he died.
Ian Smart, product architect at Royal London, says he would like to see some recognition for long-term partners. “It is unfair that the amount of tax someone pays comes down to whether they sign a legal registrar,” he says.
“Unmarried couples also miss out when the rules of intestacy apply. It would make sense to recognise these relationships, perhaps setting a time limit, after which they would qualify for the same exemptions as married couples.”
Planning with protection
Whether unmarried or facing a large liability, clients can find protection has a valuable part to play in IHT-planning strategies. Although a life insurance policy does not reduce a future liability, it can be used to cover a future IHT bill.
For example, if a married couple have an estate worth £900,000, and cannot use the RNRB as they have no children to leave their home to, they could take out a whole of life policy for £100,000 to cover the potential IHT charge.
These policies are available up to age 85 and, providing the premiums are maintained, will guarantee a payment on death. The sum insured can be adjusted if a future liability grows, with many including an option to increase cover without further underwriting.
Two different types of plan are available. The more popular is the guaranteed acceptance plan, which requires no medical underwriting and is typically sold direct, while fully underwritten policies are more common in the adviser market and can be arranged for much larger sums insured.
Although providing medical information can result in lower premiums for clients in good health, insurers are recognising the need for guaranteed acceptance plans in the adviser market. For example, last November, AIG Life launched its Over Fifties Life Plan, allowing advisers to arrange up to £15,000 of cover for their clients without any underwriting.
Matter of trust
With both types of plan, it is also important to ensure they do not inadvertently add to a future IHT problem. Placing a life insurance policy in trust ensures that, rather than being paid into the deceased’s estate and potentially increasing an IHT liability, the proceeds are paid directly to a nominated beneficiary.
This can save a considerable amount of tax. As an example, take a life insurance payout of £300,000. If this were paid directly into the deceased’s estate, and assuming their other assets exceed the nil-rate band, this payout could generate an additional IHT liability of £120,000.
There are also additional benefits of using a trust. “By writing a life insurance policy in trust, policyholders can make the sure the correct recipient gets a timely payout, without having to wait for the probate process, which can take a considerable amount of time,” says Andrew Gilbert, head of life products at LV.
In spite of these benefits, only a small proportion of life insurance policies are written in trust. Addressing this is simple and, in most cases, free. Life insurers can provide the necessary documentation to put a policy into trust, either when it is taken out or at a later date.
Mr Smart says this presents significant opportunities for advisers. “Different types of trust are available for protection so there is a need for advice,” he explains. “If it is a simple life insurance policy, a gift trust could work well, but if a client has a menu-based product a split trust will ensure they are still able to benefit from any payouts on critical illness or income protection.”
Another area where advice can be invaluable is where a policy with a large sum insured is placed in trust. Under the current rules, if this had a value – which would be the case if the policyholder were in poor health – any excess over £325,000 would be liable to a charge of 6 per cent on every 10-year anniversary of the trust.
Mr Smart says this possibility can be avoided by using the ‘Rysaffe principle’ at the outset. This involves the creation of a number of smaller trusts. “By setting up a series of trusts, each will benefit from its own nil-rate band, enabling a client to avoid this charge,” he explains. “It would be good to see this type of complexity removed in the OTS review.”
With so much on the wish list for the review, it is unlikely to be a simple process. And, while it may lead to less complexity around IHT planning, this will remain an important area for protection and financial advice.
BIG NUMBERS
£4.9bn
Inheritance tax receipts for the 2016/17 tax year (HMRC)
£325,000
IHT nil-rate band (2018/19)
40%
Standard inheritance tax rate, charged on the value of estate above the nil-rate band
301,769
Whole of life policies sold in 2016 (Swiss Re)
£109,652
Average sum assured on a new fully underwritten whole of life policy (Swiss Re)
£1,264
Average annual premium for new fully underwritten whole of life policy (Swiss Re)
