I’m pleased to announce that the blogger formerly known as Young FI Guy – or The Details Man as we shall now call him around here – has joined Team Monevator as a contributor! He’s a former accountant who was financially free by 30. We’re jealous, and so we asked him to write about taxes.
Few taxes engender controversy like inheritance tax (IHT). Despite it only being paid by around 4% of British estates, it’s subject to a great deal of debate.
But IHT is a tax that suffers from a lot of misconceptions – and it’s sometimes overlooked by those vulnerable to the taxman getting his hands on a hefty sum.
So what is IHT? Why should you care? And what can you do about it?
What is IHT?
IHT is not only a tax on death. IHT is a tax levied on what is given or transferred away.
Of course, the most common time this happens is when someone with a load of stuff passes away – because as far as I’m aware ghosts can’t own stuff.
But IHT can also kick in during a person’s lifetime, when assets are gifted or transferred.
In this sense IHT is the tax on the amount somebody is worse-off given a transfer of value.
What do we mean by transfer of value?
A transfer of value is a reduction in the value of somebody’s estate. There are typically two occasions when a transfer of value can occur:
- On a gift or transfer during the person’s lifetime – a Lifetime Transfer
- On the transfer of assets on death – the Death Estate
Push it to the limit
Each person has an effective limit on the amount of value they can transfer away without paying IHT.
- This is called the Nil Rate Band (NRB). As of 2018/19, it is £325,000.
In addition, a person also has a Residential Nil Rate Band (RNRB), a wheeze brought in by former Chancellor George Osborne. Persons can use the RNRB to pass on their home (within certain conditions) to their descendants, without paying IHT.
- The RNRB is £125,000 in 2018/19, rising to £175,000 in 2020/21.
So far so simple.
No PET–ing
The first wrinkle is that many transfers of value may not count towards the NRB.
Some transfers are Exempt – that is, they never count. For example, transfers of value between spouses are Exempt (more on that later).
Other transfers may not be immediately Exempt. Known as Potential Exempt Transfers (PETs), the most common of these is gifting assets to family members. If the giver survives seven years after the gift then it becomes Exempt.
Some lifetime transfers are not PETs. These are, shockingly, called Chargeable Lifetime Transfers (CLTs).
The most common CLTs are transfers to a Discretionary Trust above the NRB. The charge is calculated by looking back seven years from the CLT and adding up all the earlier CLTs. The sum above the NRB is charged at 20%, the amount below charged at 0%.
Death and taxes
On death, you look back seven years to find any lifetime transfers. (‘You’ being the survivor or their representatives. The deceased being engaged elsewhere…)
Any lifetime transfers made more than seven years ago become Exempt.
IHT is charged at 40% on the sum of the estate and lifetime transfers made in the last seven years, above the NRB
This charge is tapered for gifts older than three years but less than seven years.
Any IHT due on the estate is reduced by any IHT already paid on the lifetime gifts captured.
Why should you care about inheritance tax?
Three reasons:
- IHT can be a very large amount of tax to pay.
- The Government offers lots of ways to legally mitigate paying those large amounts.
- With good planning, there may not be any IHT to pay at all.
As a born and bred East Ender – and a Chartered Accountant – I’m aware that for some, legally sidestepping paying tax is a popular pastime.
I’m not here to comment on whether that’s morally right or wrong. All I can do is offer some general thoughts as to what someone can do to legally reduce a potential IHT liability.
Let’s look at some – by no means all – of the things you can consider doing.
Ways to mitigate your IHT bill
#1 Make Exempt gifts
This method is very well-known, so I’ll be brief.
Exempt gifts don’t get taxed at all.
Each person can give away up to £3,000 each year. If you don’t use all your allowance in one year, you can use it in the following year. After that, you lose it.
You can give away £250 to as many people as you like. If you give more than £250 it becomes a PET.
A gift to a couple on their wedding is Exempt up to various limits.
As mentioned before, gifts between spouses are Exempt, too.
Finally, gifts out of ‘normal expenditure’are also exempt if it’s a normal expenditure, made from income, and leaves the gifter with enough income to maintain a normal standard of living.
Pros: Easy to do, no tax to pay.
Cons: These are small beer amounts.
#2 Make PETs and survive seven years
Pros: Easy to do, can transfer large sums of money.
Cons: If you don’t survive seven years then there’ll be some tax to pay. Once you’ve given it away you’ve lost control of the money.
#3 Trusts
There are several types of trust you can gift assets to and potentially cut your IHT liability:
- Discretionary Trusts – You transfer assets to some trustees to look after. They distribute it according to their discretion, but in accordance with your ‘wishes’. Discretionary trusts are quite flexible, but anything paid into them above the NRB counts as CLTs. These trusts also have extra anniversary IHT charges. One major benefit is that you can put money away in a trust without knowing who it may ultimately go to, or where it might be inappropriate to give Jr full control of the money (if, for example, they have a fondness for lots of expensive shiny things!)
- Bare Trusts – You transfer assets to a trust set up with a specific beneficiary. These count as either exempt or PETs. Once the assets are in the trust you have effectively lost control of them – Jr can plunder the assets from age 18!
- Loan Trusts – In effect you provide an interest-free loan to a trust. The trustees invest the money in a bond. The loan stays in the estate but the return on the bond sits outside the estate. Set up as either a Discretionary or Bare Trust.
- Discounted Gift Trust – You gift capital to a trust in exchange for a regular withdrawal for life. Usually invested in a bond. At the outset, you agree the ‘discount’ with HMRC. This discount is the amount of the capital that becomes immediately Exempt. The rest counts as a CLT. Set up as either a Discretionary or Bare Trust.
Wealthy families use discretionary trusts for several reasons:
1. The money you put in below the NRB is IHT-free, once seven years are up. You can then put another lot up to the NRB in. So over time, you can potentially put huge sums away, with a low risk of a charge.
2. The gains on the assets will be IHT-free (as they are no longer yours). The trust does have to pay income and gains tax, but with some careful management you can also avoid paying lots of that, too.
3. Discretionary trusts are helpful where you don’t know who the money will go to (perhaps you haven’t had children yet) or you don’t want to risk giving the money away and seeing it all wasted. The trustees will act in the interests of the beneficiaries, but according to your wishes. So, for example, your 21-year-old black sheep of a son can’t go out and blow it all on illegal substances and strippers. (Or at least not all at once.)
4. For wealthy families, discretionary trusts typically don’t count as personal assets for things like divorce, bankruptcy, and so on – the idea is that anybody you don’t want getting their grubby mitts on what’s in it, can’t. But it may end up coming down to the decision of a court in any individual case. (This does not constitute legal advice, which of course you’ll want to pay for if going down this route.)
Pros: Can transfer large sums of money, assets in the trust can be paid out to beneficiaries far quicker than the estate, Discretionary Trusts keep some element of ‘control’ on the transfer.
Cons: Still likely to pay some tax, you still lose some control on transfer, somewhat costly and complex.
#4 Business Relief
You get a 100% reduction in IHT if you transfer a trading business or shares in an unlisted trading company that you’ve held for at least two years.
You get a 50% reduction on the transfer of business assets used in a trading company or business that you’ve held for two years.
AIM shares also count for business relief (if they are trading companies). Enterprise Investment Schemes do too, and they also have some income tax and capital gains tax benefits.
Pros: You get to keep some control of the investment (as, say, a company director). No need for trusts.
Cons: Risky assets, talk of legislative changes.
#5 Agricultural Property Relief (APR)
Like Business Relief, but for agricultural land and properties. Depending on the conditions you can get a 50% or 100% reduction.
Pros and cons: As for Business Relief, except the assets are perhaps even more esoteric.
#6 Life Policies
A whole-of-life insurance product written into trust. Two types: Unit-linked and Guaranteed.
[Update: Whole-of-life policies are apparently no longer being written, though many are still in force. Thanks to IFA Mark Meldon in a comment below for the heads-up on this.]
Unit-linked policies typically have a set premium for ten years, but the premium is reviewable afterwards and can jump significantly.
Guaranteed policies have fixed premiums and sum assured.
Pros: Unit-linked policies can give some ‘thinking time’. With a Guaranteed policy you can guarantee or ‘lock-in’ a relatively set IHT liability. Life policies can offer peace of mind. Written in trust means faster pay-out on death.
Cons: You only get the lump sum if you keep paying premiums, counter-party risk with the life office used, unit-linked policies can go up or down in value.
#7 Defined Contribution Pension Schemes
Recent pension changes mean Defined Contribution pension schemes are typically Exempt from IHT.
If you die before age 75, the pot is transferred to the beneficiary tax-free.
If you die after age 75, withdrawals from the pot are taxed at the beneficiary’s marginal rate.
Pros: You use an ‘Expression of Wishes’ to tell the pension scheme who you want money to go to. If you direct them (via a will for example) the pot is not exempt.
Cons: There may be Lifetime Allowance charges to pay, depending on the pot value.
Final words
I’ve tried to keep this post as light as possible – there are of course lots more rules behind everything I’ve written. If you’re considering your estate planning options, it’s important to get professional advice from an expert.
Finally, it’s cliché but don’t let the tax tail wag the investment dog! It’s a mistake to make planning decisions based purely on mitigating taxes, without considering the potential additional risks.
Always think carefully about whether an option is suitable for you in the bigger picture.
Further reading on IHT
Read all The Detail Man’s posts on Monevator.
