If you are confused by the UK’s inheritance tax regime, recent research shows that you are not alone. Yet getting your inheritance tax planning wrong could mean your family is faced with an unexpectedly high inheritance tax (IHT) bill.
A recent survey carried out by Canada Life revealed that over three quarters (77%) think the UK’s IHT rules are too complicated. Yet despite this, only a third (33%) have sought professional advice on IHT planning. We understand that this is a sensitive subject, but by failing to get advice, planning opportunities can be missed.
Early preparation is the key to success. Taking advantage of alternative methods to secure wealth and to shelter your estate will ensure that more wealth can be passed on to the next generation. So what can you do?
The first thing is to make a will. Dying intestate (without a will) could mean you don’t make the most of your IHT planning options. It could also result in relatives other than your spouse or registered civil partner being entitled to a share of your estate, and this might trigger an IHT liability.
You then need to understand the IHT rules. Currently, every individual in the UK, regardless of marital status, is entitled to leave an estate worth up to £325,000 tax-free. This is known as the ‘nil-rate band’. Anything above that amount is taxed at a rate of 40%. If you are married, or in a registered civil partnership, then you can leave your entire estate to your spouse or partner. The estate will be exempt from IHT and will not use up your nil-rate band.
Instead, the unused nil-rate band is transferred to your spouse or registered civil partner on their death. This means that should you and your spouse pass away, the value of your combined estate has to be valued at more than £650,000 before the estate would face an IHT liability.
On top of this, there is now the Residence nil-rate band (RNRB). Introduced in 2017, this ‘family home allowance’ can be claimed on top of the existing nil-rate band. It is currently £125,000 per person (2018/19) and will increase annually by £25,000 each April until 2020, when the designated £175,000 maximum is reached.
The RNRB is only available where a property that is (or was) used as the deceased’s main residence is passed to a direct descendant. From 6 April 2021, the RNRB will then increase each tax year in line with CPI. The RNRB is also transferable between married couples and civil partners to the extent that it is not used on the first death. The RNRB is then tapered by £1 for every £2 when a total estate is worth over £2 million.
As you can see, the RNRB rules and their outcomes are a bit complicated and many people’s houses and estates could still be liable to IHT on the amount over and above the RNRB limit - almost enough reason in itself to get financial advice?
So what else can you do?
Make lifetime gifts
The starting point is to look at gifts. Gifts made more than seven years before the donor dies, to an individual or to a bare trust (see below), are free of IHT. So it might be wise to pass on some of your wealth while you are still alive. This will reduce the value of your estate when it is assessed for IHT purposes, and there is no limit on the sums you can pass on. You can gift as much as you wish – this is known as a ‘Potentially Exempt Transfer’ (PET).
If you live for seven years after making such a gift, then it will be exempt from Inheritance Tax. However, should you be unfortunate enough to die within seven years, then it will still be counted as part of your estate if it is above the annual gift allowance. You also need to be particularly careful if you are giving away your home to your children with conditions attached to it, or if you give it away but continue to benefit from it. This is known as a ‘Gift with Reservation of Benefit’.
After that, there are several steps that you can undertake, starting with taking advantage of exemptions, such as your £3,000 a year annual allowance, plus the small gift exemption, which allows you to give up to £250 to as many people as you like. There are also wedding gifts and donations to qualifying charities that you can make, along with gifts out of any excess income.
Set up a trust
As well as gifts, family trusts can be useful as a way of reducing IHT, making provision for your children and spouse, and potentially protecting family businesses. Trusts enable the donor to control who benefits (the beneficiaries) and under what circumstances, sometimes long after the donor’s death. Compare this with making a direct gift (for example, to a child) which offers no control to the donor once given. When you set up a trust, it is a legal arrangement, and you will need to appoint ‘trustees’ who are responsible for holding and managing the assets. Trustees have a responsibility to manage the trust on behalf of and in the best interest of the beneficiaries, in accordance with the trust terms. The terms will be set out in a legal document called ‘the trust deed’.
There are several types of trust that you can consider.
Bare (Absolute) Trusts
The beneficiaries are entitled to a specific share of the trust, which can’t be changed once the trust has been established. The settlor (person who puts the assets in trust) decides on the beneficiaries and shares at outset. This is a simple and straightforward trust – the trustees invest the trust fund for the beneficiaries but don’t have the power to change the beneficiaries’ interests decided on by the settlor at outset. This trust offers potential Income Tax and Capital Gains Tax benefits, particularly for minor beneficiaries. However, it should be borne in mind that if a parent creates a bare trust for their minor unmarried child – and the gross income is more than £100 a year – under the ‘parental settlement’ rules, all the income will be taxed on the parent.
Life Interest Trusts
Typically, one beneficiary will be entitled to the income from the trust fund whilst alive, with capital going to another (or other beneficiaries) on that beneficiary’s death. This is often used in Will planning to provide security for a surviving spouse, with the capital preserved for children. It can also be used to pass income from an asset on to a beneficiary without losing control of the capital. This can be particularly attractive in second marriage situations when the children are from an earlier marriage.
Discretionary (Flexible) Trusts
The settlor decides who can potentially benefit from the trust, but the trustees are then able to use their discretion to determine who, when and in what amounts beneficiaries do actually benefit. This provides maximum flexibility compared to the other trust types, and for this reason is often referred to as a ‘Flexible Trust’.
Beyond gifts and trusts, you can consider other options, such as taking out life cover, looking into business property relief and also using a deed of variation, which can be designed to meet your individual circumstances and objectives. Bear in mind that tax rules can change and any benefits depend on personal circumstances.
A couple of other options for consideration too. Firstly, it’s possible to create an IHT free ISA, as some AIM shares can qualify for an IHT exemption after two years. This applies even if the ISA proceeds are paid to someone other than your spouse or civil partner when you die. Obviously, AIM shares are a higher-risk investment, so you may want to get personal financial advice before investing.
Secondly, you may want to consider your pensions, as under the new pension freedoms, it is possible to pass on pension assets outside of your estate for IHT purposes. Pensions are now normally tax free on death before 75. After 75, beneficiaries are charged their marginal rate of income tax when taking the money. So basic rate taxpayers will pay 20% for withdrawals that stay within the basic rate tax band, which is obviously half the IHT rate - and, in some cases, they could pay no tax at all.
Tax rules and benefits are constantly changing, so it could well pay to get specialist IHT advice. If you believe you may fall into the IHT net, contact Kellands. We look forward to hearing from you.
 Canada Life’s annual Inheritance Tax monitor survey of 1,001 UK consumers aged 45 or over with total assets exceeding the individual Inheritance Tax threshold (nil-rate band) of £325,000. Carried out in October 2017.
Information is based on our current understanding of taxation legislation and regulations. Any levels and bases of, and reliefs from, taxation are subject to change.