A long blog this week but a big topic.
HM Revenue & Customs data released last month revealed that a record £7.5bn in Inheritance Tax (IHT) was paid to the Treasury in the 2023/24 tax year, a 5.6% increase on the previous year (which was also a record).
This comes as no surprise – rising asset prices and a continued freeze in the thresholds at which IHT kicks in have brought more estates into the crosshairs of IHT.
In this week’s blog, I explore five common planning opportunities to mitigate the potential IHT charge on your estate.
i. Pensions
Generally speaking, defined contribution pension savings (aka. ‘pension pots’) sit outside your estate for inheritance tax purposes. Any residual value can therefore be passed on to the next generation completely free of IHT.
It follows that pensions now play a key role in inheritance tax planning.
The strategy is fairly simple – pay as much into your pension as possible, and then leave the pot untouched for the ultimate benefit of your nominated beneficiaries, e.g. children or grandchildren. In the meantime, you might draw an income from other assets or investments that do form part of your estate.
Consider the following example:
James and Kate are married and have combined assets worth £1.75m, comprising a main residence (£750k), stocks & shares ISAs (£350k), cash (£150k) and pensions (£500k). On death, they plan to leave everything to their two children.
In terms of their IHT liability:
- The pensions are exempt, reducing their estate value to £1.25m,
- Of this, £1m is free from IHT - 2x £325k nil-rate bands plus 2x £175k residence nil-rate bands,
- The excess estate value of £250k shall be liable to IHT at 40% resulting in a potential charge of £100k.
They require around £40k a year to meet ongoing spending needs.
Rather than drawing any income from their pensions, which are exempt from IHT, they instead take regular withdrawals from their ISAs and surplus cash, which form part of their estate, thereby saving an effective 40% IHT on each withdrawal.
In many ways, pensions are the perfect estate planning tool – the monies sit outside your estate for IHT but remain available to you throughout.
The only downside is that you’re limited in how much you can pay into a pension each year. Generally speaking, this is the lower of your relevant earnings (principally work-related income) and available annual allowance (including any carry forward from the last three tax years).
Most retirees will be limited to paying in the minimum £3,600 gross a year, and only to age 75, beyond which no further income tax relief is available.
Whilst it’s good housekeeping to leave pensions untouched, this option is less effective in providing a sizeable reduction to an existing liability.
A pension is a long-term investment and funds are not normally accessible until 55 (rising to 57 from April 2028). When investing via a pension, your capital is at risk. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits.
ii. Direct gifts
For those looking to mitigate an existing IHT liability, direct gifts can be extremely effective.
First and foremost, there are numerous gifting exemptions which offer an immediate saving:
- A £3,000 ‘gift allowance’ per person per tax year, plus any unused allowance from the previous year,
- The ‘Normal Expenditure out of Income’ exemption, whereby you can give away up to 100% surplus income, as long as this is done regularly, be it weekly, monthly or annually,
- Wedding gifts of up to £5,000 for a child, £2,500 grandchild or £1,000 anyone else,
- £250 small gifts to as many individuals as you like (as long as these don’t form part of the £3,000 gift allowance).
In each case, such gifts are immediately exempt from IHT, i.e. no 7-year rule (more on this shortly).
In terms of larger gifts, these are classed as so-called ‘potentially exempt transfers’ - as long as the gift is made directly and absolutely, there is no immediate charge to IHT, regardless of the gift amount. However, the donor (i.e. the person making the gift), must survive 7 years for the gift to fall outside their estate for IHT.
Returning to the previous example:
Assume now that James and Kate have surplus income and are therefore in the position to give away some of their capital to help mitigate the potential IHT charge on their estate.
- They choose to gift £200k to their children (£100k each),
- There is no immediate IHT liability on the gifts,
- Having not made any previous gifts, the first £12,000 is covered by their gift allowances – 2x £3,000 for the current tax year, plus carry forward from the previous one,
- The balance (£188,000) shall be subject to the 7-year rule. That is, it would still be liable to IHT were they to die during this period.
- However, on the 7th anniversary, the gifts would now be completely exempt from IHT, resulting in an effective ‘cliff edge’ saving of £75,200 (40% x £188,000).
Direct gifts can be extremely effective:
- They’re simple – you simply transfer money or assets to the intended beneficiary,
- They’re cheap – there are no ancillary product or legal fees,
- They’re tax efficient – there’s no IHT to pay on the initial transfer, regardless of the gift amount, with a potential sizeable IHT saving after 7 years.
The other key non-financial benefit is that you get to see the recipient actually benefit from the gift during your lifetime, rather than as a legacy on death – ‘better to gift with a warm heart than a cold hand’ some would say.
Of course, there are drawbacks, most notably the loss of access and control. This is where trusts can offer a viable alternative.
iii. Trusts
Trusts work in a similar way to direct gifts, only you’re transferring money into a trust rather than directly to an individual. This enables the donor, aka. ‘Settlor’ to retain control and, in some cases, access to the monies.
They can do this by appointing themselves as a trustee, thereby maintaining control over how the underlying funds are invested and, more significantly, how they’re eventually distributed (to whom, when and how much).
This is particularly pertinent to those concerned about future matrimonial issues for their children, or simply not wanting them to have too much too soon (I come across this a lot).
Again, consider the following example:
Charlie and Claire have assets of £5m and therefore face a considerable IHT liability. They have three children, aged 16, 18 and 22. They’d rather not gift funds directly as they have concerns about their kids getting ‘too much too soon’, and around future matrimonial issues.
- They choose instead to set up a new discretionary trust. This would be classed as a so-called ‘chargeable lifetime transfer’, in which case, the maximum amount they can pay in, without incurring an immediate IHT charge is £650,000, equivalent to their combined nil-rate bands.
- Charlie and Claire appoint themselves as trustees, such that they retain control over how the monies are invested and subsequently distributed. In regards to the latter, they define a wide class of beneficiaries – their children, grandchildren and any subsequent issue, providing them with substantial flexibility.
- In terms of IHT, once 7 years have passed, the original gift of £650k will no longer be liable to IHT, providing an effective saving of £260k (40%). In fact, at this point, they could ‘go again’ and transfer another £650k into trust (assuming nil-rate band thresholds remain frozen at this level).
- In the meantime, any growth in the trust’s investments sits immediately outside their estate. For example, say the trust invests in a diversified portfolio of equities and bonds that grows at an average of 6% a year, after 5 years, the trust would be worth c. £870k and all the £220k growth would already be fully exempt from IHT, providing an effective (additional) IHT saving of £88k (40%).
When investing, your capital is at risk – the value can go down as well as up. These figures are for illustrative purposes only and do not reflect actual investment returns, which can fluctuate and are not guaranteed.
There are also certain trust structures that provide ongoing access, e.g. loan trusts, discounted gift trusts, and flexible reversionary trusts. Each of these warrants a blog of their own, but if anyone would like to know more at this stage, please let me know.
Comparing a direct gift with one into a trust, trusts are invariably more complex, more costly, and generally less tax efficient (income tax in the trust plus periodic and exit charges). However, they are still highly effective as a tool for mitigating IHT and the additional cost and complexity may be a ‘small price to pay’ for the retention of control and, with certain trust structures, ongoing accessibility.
The Financial Conduct Authority does not regulate Trusts, Estate and Tax Planning.
iv. Business Relief
Investments that qualify for Business Relief ‘BR’ can be passed on free from inheritance tax upon the death of the investor, provided the shares have been owned for at least two years at that time.
The two main types of BR investment that we advise on are:
- AIM portfolios – many companies listed on the UK’s Alternative Investment Market (AIM) are BR-qualifying,
- Traditional BR schemes – these involve investing in limited companies (run by well-known asset managers) which fund BR-qualifying activities, typically renewable energy projects and/or asset-backed lending for infrastructure development.
BR investment is particularly effective for those who may have left IHT planning a little late in life. Consider the following example:
Christian is 80 years old and has an estate worth £2m, consisting of property (£500k), cash (£250k) and investments (£1.25m). He would like to mitigate some of the potential £600k IHT liability.
He acknowledges that he’s left things a little late and also wants to ideally retain access to the funds in the event of a prolonged care need for example.
- He chooses to invest £300k (20% liquid assets) in BR-qualifying investments, a mix of AIM-listed stocks and ‘traditional BR’,
- Two years later, the investments are fully exempt from IHT, providing an effective saving of £120k (40%), subject to the performance of the underlying investments.
Relative to gifts/trusts, the main advantage of BR investment is the accelerated IHT saving – two years rather than seven. Furthermore, the investment stays in your name and can therefore be accessed if required (albeit the central case is that it should be left fully untouched).
However, such investments are high-risk and therefore only suitable in certain circumstances.
There’s also a cloud of uncertainty surrounding BR at present, with growing speculation that a future Labour investment could clamp down on the tax break, potentially tightening the criteria for qualification. Whilst one should advise on current rather than anticipated legislation, it is nonetheless an important consideration.
Business Relief investments are high-risk products and not suitable for the majority of retail investors. Investments in unquoted companies may be harder to sell and are likely to fall and rise more sharply. Tax rules could change in the future. The value of tax reliefs will depend on an investor’s circumstances.
v. Whole of life insurance
The fifth option is to take out a ‘whole of life’ (WoL) insurance policy.
Like Business Relief, this splits opinion – many wince at the notion of taking out life insurance in later years. But the maths can stack up favourably and it’s a particularly viable option for those who are ‘income-rich’ but liquid asset-poor, such as those with a sizeable buy-to-let property portfolio for example.
It’s important to consider WoL cover as a ‘transfer of wealth’ rather than pure protection policy. You pay a regular monthly premium, in exchange, your beneficiaries receive a tax-free lump-sum when you die.
Again, this is best explained by way of an example:
Shannon is 70 years old and in good health. She has considerable surplus income, as a result of a £2m buy-to-let portfolio but has little by way of other liquid assets (i.e. most of her wealth is tied up in property).
- She takes out a new WoL policy with a sum assured of £500,000 and a cost (aka. premium) of £1,300 per month / £15,600 per year. This is on a ‘guaranteed’ basis, which means both the cost and benefit will remain unchanged throughout.
- In the event of Shannon’s death, the policy would pay out a tax-free lump sum of £500,000 to her chosen beneficiaries. The policy would be written in trust, in which case, the proceeds themselves aren’t liable to IHT and are also available immediately (rather than being delayed by probate). The money could then be used to repay some of the IHT liability on Shannon’s estate.
- Whilst £1,300 pm is a sizeable outgoing, this is comfortably covered by her income surplus (and therefore itself exempt from IHT under the ‘normal expenditure out of income’ exemption). Furthermore, Shannon would need to survive 32 years before the total premiums paid exceeded the guaranteed payout on death.
The main benefits of WoL insurance are:
- Simplicity – such contracts can be set up very easily,
- Immediate cover – you’re insured from day one, i.e. no two or seven-year rule,
- Zero investment risk – the policy pays out on death; there are no underlying investments and therefore no investment risk,
- Immediate payout – by writing the policy in trust, the payout doesn’t form part of your estate and can therefore be paid out immediately on death without waiting for Probate.
The principal downside is that you’re merely providing for rather than mitigating an IHT charge.
Life Assurance plans typically have no cash in value at any time and cover will cease at the end of term. If premiums stop, then cover will lapse. Some whole-of-life plans may increase in premium at the review period.
Conclusion
As you can see, there are plenty of different options to reduce or provide for a potential IHT charge on your estate.
As a result, an appropriate IHT ‘solution’ can be tailored to your specific needs around timeframe, investment risk, attitude towards retaining control and access, etc.
In most cases, a combination of options via an ‘estate planning portfolio’ provides the optimal mix.
Some areas of Inheritance Tax (IHT) planning are not regulated by the Financial Conduct Authority. Some IHT planning solutions may put your capital at risk so you may get back less than you originally invested. IHT thresholds depend on your circumstances and may change in the future.
This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. Since I don’t know your specific situation, none of this information should be construed as tax or financial advice. It is not an offer to purchase or sell any particular asset and it does not contain all the information which an investor may require to make an investment decision. Although endeavours have been made to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of any articles.
