Reducing the impact of inheritance tax

We all have a nil rate band – in lay terms, an inheritance tax exemption – of £325,000. For couples, that is £650,000 (when one spouse dies their allowance passes to the remaining partner). 

Since April 5 2017 individuals have been able to claim an additional allowance of £100,000 to offset the sale of a family home on their death. The new tax allowance will rise to £175,000 by 2020 – meaning a couple can eventually expect to pass on £1m tax-free. 

Be aware though that this new residence nil-rate band is not designed to benefit wealthier individuals – the allowance is tapered on estates worth more than £2m – and the rules are complex. Generally speaking, to benefit, the deceased must have had a qualifying residential interest in the property – meaning it has been their home at some point – and the beneficiary must be 'closely inherited' – in other words, must be a direct descendant. 

As a result, there will still be many who need sensible estate planning advice. 

Planning process

The first task of any planner is to establish what the client has and where it is held, including pensions, which are now very IHT-efficient. If someone dies before the age of 75, any assets held within a pension wrapper can be passed to beneficiaries tax-free (subject to their lifetime allowance). After that beneficiaries pay tax at their marginal rate on drawing the assets, which might be less than the IHT rate. This makes pensions a key part of the estate planning strategy and means the adviser has an important role in helping clients decide what assets they draw on first in retirement.

If a client’s estate is likely to exceed the IHT threshold they have four options: spend, give money away, invest in IHT-qualifying assets or insure the liability. 

Gifting

The most obvious gifting strategy is through potentially exempt transfer (Pet). Clients can give their children or others as much as they like and it will be exempt from inheritance tax if they live for more than another seven years. If they die before that time, a taper potentially applies (see table).

Table

This is the cleanest way to gift substantial sums but in our experience it can encourage many people to give away too much too soon, losing control of the assets. It is possible to use trusts allowing the donor to retain some control over gifts and access. Clients may also need to consider pre and post-nuptial agreements to protect family wealth passed down the generations from disappearing in divorce settlements. A good legal partner becomes a valuable asset in serving clients here.   

The key challenge with any gifting strategy is calculating how much capital is needed to cover potential liabilities. This is an issue not just of calculating longevity, but also of budgeting for end-of-life care costs. Commonly an adviser might allow four to five years at £40,000 a year per person. That would sap savings heavily for most clients and helps flag up the seriousness of giving too much capital away beforehand.    

There are other ways to give without having to think seven or more years ahead. An underused facility is 'gifts out of normal expenditure'. Help your client document how much of their annual income they spend year to year. They can give the surplus away without the Pet rules applying as long as they are able to maintain their usual standard of living. The key is accurately recording the information. Normal gifts such as Christmas and birthday presents are included within this allowance too.

In addition to gifts out of normal expenditure, each individual has an annual exemption of £3,000 (therefore £6,000 for a couple) worth of gifts they can make each tax year without these gifts being added to the value of an estate. This can be carried back one year if a client has not fully used the previous year’s exemption.

It is also possible to give wedding presents of up to £1,000 per person (£2,500 for a grandchild or great-grandchild and £5,000 for a child).

Also exempt are payments to help with another person’s living costs, such as an elderly relative or a child under 18.

Finally, it is possible to give any number of gifts of up to £250 per person during a tax year as long as another exemption has not already been used on the recipient. 

Gifts to charity

Another variant of the giving strategy is to gift money to charity, known as leaving a charitable legacy. Charitable donations do not count towards the total taxable value of a client’s estate. Giving away 10 per cent of their net estate reduces IHT tax to 36 per cent. 'Net estate' means the element of the estate eligible for IHT. 

Those already planning to gift more than 4 per cent of their net estate to charity will actually leave their beneficiaries better off by lifting this to 10 per cent. Others who were not planning charitable donations might find the numbers encouraging. Someone with a net estate of £250,000, leaving £25,000 to charity, reduces the impact on beneficiaries by just £6,000. 

IHT-qualifying investments

An alternative strategy, particularly useful in later-life tax planning, is investing in assets that qualify for business relief – business property relief, as it used to be known. The big advantage here is the speed at which the assets fall out of the estate – just two years – and the fact that the client retains access and control. 

Investments eligible under this scheme include Seed Enterprise Investment Schemes (SEIS), Enterprise Investment Schemes (EIS), Venture Capital Trusts (VCTs) and certain AIM shares or portfolios. 

The downside is that they can be higher risk investments and not normally suitable for older people. They can be illiquid and the underlying manager fees can be high. An AMC of 2.5 per cent to 3 per cent is not untypical and if held over 20 years that could seriously erode value.   

Insurance

Life cover is a useful consideration that can also help. It is possible to put in place whole-of-life insurance written on a joint-life, second-death basis with the sum assured written in trust outside the estate. This can cover the IHT tax costs, meaning properties do not necessarily have to be sold to allow a quick settlement of probate and leaving beneficiaries time to make sometimes difficult decisions. Later-life cover can be expensive, which is why advisers need to consider all strategies and the particular circumstances of each client.

Other considerations

As part of the estate planning process a good adviser will also check that wills and powers of attorney are in place and up to date and that beneficiaries have been appointed to pension assets. They will obviously also remind clients that their circumstances can change and tax treatments too – so regular reviews are highly advisable. 

In conclusion, clients need to be wary of focusing too heavily on ducking an IHT bill, taking unnecessary risks and incurring costs in the process. That said, there are plenty of ways a good adviser can help reduce the impact of IHT on a client’s estate.

Ned Francis is a chartered financial planner at James Hambro & Co

Key points

We all have a nil rate band when it comes to inheritance tax.

Each individual has an annual exemption of £3,000 worth of gifts they can make each tax year.

An alternative strategy is investing in assets that qualify for business relief.