15 Apr 2016
Author: Stephen Breen
The recent news coverage of the Prime Minister’s tax affairs revealed amongst other things that his mother gifted £200,000 to him back in 2011 – a sum that might otherwise have been subject to a hefty inheritance tax bill of 40% on her demise. Predictably, a number of papers covered this in a sensationalist way, but the arrangement was perfectly within the law and a good example of sensible tax planning.
Here, we look at how inheritance tax works and how anyone can manage their finances to ensure they pay as little as possible – the legal way.
An introduction to IHT
Currently the first £325,000 of your estate (the ‘nil rate band’) is exempt from inheritance tax (IHT). Any amount above this is subject to a 40% fee. However, there are some concessions – married couples or couples in a civil partnership can pass their assets to their partner free from IHT. Then, the surviving partner can use any unused portion of their deceased partner’s nil rate band to minimise their own IHT liability. Couples are therefore able to shelter up to £650,000 of their combined estate from inheritance tax.
Changes to IHT
From April 2017, a new family home allowance will be introduced to IHT, effectively increasing the nil rate band for some people. In 2017/18, the amount will be £100,000, increasing to £175,000 in 2020/21. In effect from 2010, qualifying couples will be able to shelter up to £1 million of their combined estate from inheritance tax. To be eligible for the new allowance, you will need to (i) be married or in a civil partnership, (ii) own a family home and (iii) have children that you can pass on your estate to. Sadly, these three conditions exclude a large percentage of the population in the UK and for many, further careful planning will be necessary.
Minimising IHT liability – PETs
You can reduce your IHT liability by making gifts, known as ‘Potentially Exempt Transfers’, before your death. This is how David Cameron’s mother was able to gift £200,000 without any tax liability – and provided that she survives until 2018, no IHT will be payable on this sum. The gifts can be of any size and made to any individual of your choosing – but they must be genuine. You cannot, for example, ‘give’ a valuable asset but keep hold of the asset until your death.
Unfortunately, Potentially Exempt Transfers are only likely to be of benefit for the wealthiest. For most people, the biggest asset they own is their home which cannot be gifted to avoid IHT, unless they actually move out of the property.
Further, there is the risk that if you make a gift and then die within seven years, the value of the gift will be added to your estate and may be subject to inheritance tax. Gifts made within 3 to 4 years could be subject to 32% tax, which reduces to 24% for gifts made within 4 to 5 years, 16% for gifts made within 5 to 6 year and 8% for gifts made within 6 to 7 years.
In addition to Potentially Exempt Transfers, you can make one-off gifts to avoid IHT. These can be of any amount, up to the value of £3,000 per year. You can also make an unlimited amount of small gifts up to the value of £250 each.
If your child is getting married, you can gift up to £5,000 free from tax – or if it is your grandchild marrying, you can gift up to £2,500. In addition you can make unlimited payments from your income – for example, to help children or grandchildren – provided you make the payment regularly and it does not affect your standard of living.
Using a trust
Grandparents can set up a bare trust for their grandchildren and the interest earned can be set off against the child’s personal allowance which is the same as the adult rate – currently £11,000 for the tax year 2016/17. The child will not have access to the money until they reach 18 years of age.
Gifting a pension or ISA
Since April 2015, married couples and civil partners have been able to pass on an ISA to their surviving partner, with no income tax or capital gains to pay on the underlying investments. Prior to this change, the transfer of an ISA to a surviving spouse would not have attracted IHT but the underlying investments were liable for both income tax and capital gains tax.
You can also pass on your pension pot to your choice of beneficiary, without it being liable for IHT. Additionally, should you then die before reaching the age of 75, your beneficiaries will not have to pay income tax when they draw money from the pension pot. If you die aged 75 or older, the pension pot is still free from IHT liability but income tax will be payable on any drawings made by the beneficiaries at their highest marginal rate.
A number of investments qualify for IHT exemption – these include over 500 stocks listed on the Alternative Investment Market. These are eligible once they have been held for two years, after which they are deemed as ‘business assets’.
There is no list of which stocks qualify, but there are a number of rules to help identify those which may be suitable. Crucially the company must not be an investment company – so companies that make or hold investments or deal in shares, land or buildings will not be eligible. Once a suitable company has been identified, it is important to keep checking its status as it may lose its IHT exemption status in the future.
In addition to certain AIM investments, Enterprise Investment Scheme shares are eligible for IHT relief, once they have been held for two years. Individuals can invest up to £1 million each year in an EIS and benefit from upfront tax relief at 30%. If the investment is held for at least 3 years, there is no CGT to pay once it is sold. However, dividends from the EIS are subject to income tax.
Our later life planning team are here to offer you further advice on your inheritance tax planning – get in touch now.