What do clients need to know about inheritance tax planning?

Inheritance tax (IHT) can catch clients out if they have not planned for what happens to their assets after they have died.

Research published in April by Time Investments found that of the 500 people aged over 55 with assets above the IHT threshold surveyed, 36 per cent who use a financial adviser had not yet considered inheritance tax planning.

Henny Dovland, business development manager at Time Investments, believes it’s an area of end of life planning where clients value support and professional advice because of its complexity.

“Clients want to get it right and sometimes having that advice gives them confidence. That’s what advisers can help clients with, it’s giving them confidence to put appropriate planning in place,” she says.

It can come as a shock to a beneficiary to learn they may have to sell a property that has been in the family for generations because of lack of IHT planning.Femi Folorunso

Firstly, it helps to know the facts about IHT and how it works.

Femi Folorunso, a consultant at Mattioli Woods, explains: “The current inheritance tax threshold is £325,000 per person. 

“This increases to £650,000 for a married couple, as long as the first person to die leaves their entire estate to their partner. Anything over this limit could be subject to 40 per cent tax.”

He continues: “There is also the recently introduced Residence Nil Rate Band (RNRB), frequently referred to as the ‘main home allowance’. This is on top of the standard IHT threshold. 

“To be eligible, you must pass your home – or a share of it – to linear descendants (i.e. your children or grandchildren). The home allowance is currently £125,000, but will rise incrementally to reach £175,000 in 2020-21 and, thereafter, in line with the Consumer Price Index."

He emphasises the need for clients to be aware of how their circumstances fit into the prevailing IHT regime and to explain this to beneficiaries so there are no nasty surprises.

“For heirs, an understanding that they may not inherit 100 per cent of the asset left to them, and may need to pay 40 per cent on a small or significant part of it, is important to manage expectations,” notes Mr Folorunso.

“It can come as a shock to a beneficiary to learn they may have to sell a property that has been in the family for generations because of lack of IHT planning.”

Estate planning

Property is probably the biggest asset most people have, so understanding how this is affected by IHT is vital.

“Property is almost always a major asset for investors”, observes Joe Roxborough, chartered financial planner at Ascot Lloyd, “and the government has grabbed headlines by increasing the nil rate band to £1m for those with property assets with the RNRB”.

He adds that as with all government giveaways, the devil is in the detail. 

“Most importantly, if the total estate of the deceased is worth more than £2m, the extra RNRB will be eroded away – back to zero, if the estate is big enough,” Mr Roxborough points out.

“Secondly, the beneficiary must be a direct descendent of the deceased – so nieces and nephews, for example, will not be able to benefit. 

“This is the tip of the iceberg. If clients can benefit from the full £1m allowance, this will be a huge windfall for their beneficiaries, so we continually try to arrange assets for our clients to meet the criteria needed where possible.”

Clients may also have questions about what happens to pensions when it comes to end of life planning.

Given that pension pots could be fairly sizeable by the time a relative passes away, clients will want to know what can and cannot be passed on, and what the taxman is owed.

Fiona Tait, technical director at Intelligent Pensions, explains: “One thing to remember is that any benefits held within a pension plan at the time of death do not form part of an individual’s estate and can usually be passed on free of IHT.

“People with personal pensions, or other defined contribution (DC) arrangements, have the freedom to nominate anyone that they choose to receive the balance of their fund on death, while spouses and dependents of those in final salary schemes will receive benefits in line with the scheme rules.”

So far, this all sounds fairly straightforward. 

Under the potentially exempt transfer rule, assets can be given away to anyone and, provided the gift is made more than seven years prior to the death of the donor, the asset will not normally form part of their death estate.Tim Bennett

How does this work in practice then?

As Ms Tait sets out: “What this means is that older people who are lucky enough to have sufficient pension and non-pension assets should consider drawing down the latter to meet expenses, rather than the pension fund so that they can pass on as much as possible without attracting IHT.” 

She suggest those with DC pensions should give serious consideration to who they want to nominate to receive the pension fund on their death.

“Most people will automatically nominate their spouse,” she acknowledges. “However, the spouse will receive the rest of the estate without paying IHT and so it could make sense to pass on these benefits to someone, such as an adult child or other relative, who would not be exempt from IHT.”

The burning question for most clients is how can they mitigate the impact of inheritance tax on their estate.

Blunt tool

“IHT is a very strange tax,” Mr Roxborough admits. 

“Firstly, it’s a very blunt tool, levelled at a rate of 40 per cent at almost all assets above the nil rate band, and can also be used retrospectively on gifts already given by the deceased if the timespan between gift and death is insufficient.

“That's the bad news, but the good news is that, with a little planning, it is also an eminently avoidable tax – perhaps more so than any other.”

Gifting, as Tim Bennett, head of education at Killik & Co, points out, is one of the main ways to reduce inheritance tax legally.

“Under the potentially exempt transfer rule, for example, assets can be given away to anyone and, provided the gift is made more than seven years prior to the death of the donor, the asset will not normally form part of their death estate,” he explains. 

“One caveat, however, is that a gift may be subject to capital gains tax at the time it is made so, once again, this is an area that needs careful thought.”

Helen O’Hagan, technical manager in Prudential’s technical team, says advisers may want to consider exemptions as another way to reduce the amount of IHT payable on a client’s estate.

She outlines three exemptions:

• Each tax year an individual can gift up to £3,000, which can be useful if paying premiums on a life policy to cover the inheritance tax.
• Each year an individual can gift £250 to as many individuals as they like, as long as it is not used in conjunction with other exemptions.
• There are also exemptions for gifts on marriage, gifts to help with the living costs of dependents and gifts out of surplus income.

Trust planning

Ms O’Hagan acknowledges: “There are many ways to do inheritance tax planning with the use of trusts, which have been used for many years. These trusts will normally have been through a process to ensure they are ‘fit for purpose’ as a tool to help mitigate IHT.

“An adviser will guide a client through a number of questions to ascertain the type of trust which is best suited to a client’s particular circumstances.

“A big factor is the access that the client needs from those funds now and in the future.”

She lists the three most common IHT trusts:

1.    Gift trust – client must be willing to give up all access to funds.
2.    Loan trust – client has access to his/her capital but not the growth on the investment.
3.    Discounted gift trust – the client carves out a fixed regular payment stream for his/her lifetime.

One of the main pitfalls to avoid is giving away too much, too soon.

This might sound obvious, but Scott Gallacher, chartered financial planner at Rowley Turton, cautions he has seen this happen before.

“Gifting money early, either directly or via trust arrangements, can be key to reducing your inheritance tax liability, but it’s important to ensure that you do not leave yourself at risk of running out of money yourself,” he says. 

“I’ve seen very poor parents and very wealthy children created from too aggressive inheritance tax planning.”

eleanor.duncan@ft.com