Financial planning, Taxation
Your essential guide to inheritance tax planning
Prudent inheritance tax planning is crucial to protect the value of your estate and make sure your loved ones receive what is rightfully theirs after you pass away.
More people than ever now find themselves falling into the bracket where inheritance tax (IHT) can become a costly issue – and all too often families lose out because they fail to plan ahead. The latest ONS findings show that IHT receipts in the UK amounted to £6 billion in 2021, up nearly 15% from the previous year. This is partly attributed to rising property prices, but more so due to a failure to mitigate our exposure to inheritance tax.
Whilst there is never a bad time to start planning for your future, most people aim to establish a secure arrangement for their estate as they’re moving into retirement. As this is a relatively complex area of tax, it pays to seek the guidance of an experienced inheritance tax advisor to discuss your situation and make an informed decision regarding the future of your estate.
What is inheritance tax?
Inheritance tax is levied on the transfer of your estate after you die, which includes your property, money, possessions and other assets. More often than not it is paid by the estate of the person who has died, though in some cases it may instead be paid during that person’s lifetime.
The nil-rate tax band for IHT has been frozen at £325,000 since 2009, which means that no IHT is due to be paid on the first £325,000 of your total estate value. After that, IHT is charged at 40% as standard, though there are a number of further exemptions, reliefs and allowances from which you may be able to benefit.
It’s worth noting that married couples and civil partners have the ability to transfer any of their unused tax allowance to their living partner when they die, which effectively gives them a joint nil-rate band of £650,000.
Direct gift allowances
There are a number of gift allowances available that can help offset some, or potentially all, of the inheritance tax due to be paid on your estate.
For instance, you and/or your partner can give away £3,000 worth (£6,000 in total) of tax-free gifts each tax year without this being added to the value of your estate. This is known as your ‘annual exemption’. You can carry any unused annual exemption forward to the next year, but only for one year.
Each tax year, you can also give away:
- Wedding or civil ceremony gifts of up to £1,000 per person (£2,500 for a grandchild or great-grandchild, £5,000 for a child)
- Gifts to charities and political parties
- You can give as many gifts of up to £250 per person as you want during the tax year as long as you have not used another exemption on the same person
Beyond these exemptions, direct gifts may also qualify as a ‘potentially exempt transfer’ (PET). This means that any gift, no matter the value, will become exempt from IHT if the individual survives for a period of seven years after making the transfer. There is also a taper relief system if the person giving the gift dies within seven years.
Are there any risks involved with giving direct gifts?
Although transferring direct gifts can be a great way to mitigate your exposure to IHT, it’s important to be aware of several consequences in doing so, including:
Loss of control of your capital – By gifting property, money or any other asset to another person, you are effectively relinquishing your ownership and legal control of that asset.
Profligate spending by your children – If you are planning to give a gift to your children, it’s only natural that you want them to protect the value of this gift for years to come. It’s a good idea to talk to your children to lay out a plan prior to making the transfer to avoid the risk of them overspending or squandering key opportunities.
Capital becoming available to creditors – If the person to whom you are transferring a gift has outstanding debt then the capital they receive will likely be considered as new collateral by their lenders.
Exposure to spouses and partners – The spouse or partner of your chosen recipient may maintain a legal right to ownership to a portion of the gift should they divorce or break up.
Instead of transferring direct gifts, you can also transfer a portion of your estate as a gift to a discretionary trust. This structure gives you (the settlor) and your appointed trustees more control when arranging the transfer of your assets, and can be tailored to the needs of you and your family.
Unlike direct gifts, your chosen beneficiaries will receive their inheritance under specific conditions at the discretion of your trustees, ensuring that your wishes are fulfilled in the best interest of all involved. There is also more flexibility and protection should circumstances change for any reason, and the trust structure can help prevent your inheritance from falling into the hands of creditors.
Another key advantage of discretionary trusts is that they can help reduce inheritance tax liabilities because the trust is considered as a separate entity from your estate. Your beneficiaries also do not need to obtain probate which ensures a smoother transition of funds and assets. Make sure to talk to a specialist trust advisor as they will be able to structure your trust with tax efficiency in mind.
What are the drawbacks of discretionary trusts?
Trusts tend to be more complex when compared with other methods of transferring inheritance and generally involve more time, effort and costs to establish and maintain.
Potential for additional charges
Gifts into a discretionary trust are chargeable lifetime transfers (CLTs), which may attract an immediate tax charge where the value of the gift exceeds your combined nil-rate band of £650,000. There may be an additional charge should the settlor die within seven years of creating the trust, and an exit charge when the capital is withdrawn.
Power to trustees
Your chosen trustees are given greater power and responsibility in carrying out your wishes and so it’s important to select people you can trust to do so.
As an alternative to a discretionary trust, you may wish to consider setting up an alternative trust structure, such as a bare trust or a loan trust.
With a bare trust, your assets are held in the name of a trustee but go directly to the beneficiary who has a right to both the assets and income of the trust. It’s important to note that neither the beneficiaries nor their share of the trust can be changed after the trust has been set up.
Beneficiaries with legal capacity (generally, at age 18 in England and Wales and age 16 in Scotland) have the right to demand their vested share of the trust fund at any time. As such, this type of trust is unlikely to work for your children but would be suitable for grandchildren under the age of 18.
With a loan trust, the settlor makes an interest-free loan which is repayable on demand to their chosen trustees. The trustees subsequently invest the proceeds of that loan and the growth on the capital is held for the beneficiaries and cannot be retrieved by the settlor.
Any outstanding loan will form part of the settlor’s estate on death, but the growth is effectively free from any IHT from the outset. The overarching benefit of loan trusts is that the growth can either be advanced to the beneficiaries before death, on death or held in the trust after death, if the trustees wish.
Loan trusts can either be set up as a bare trust or discretionary trust. If a discretionary trust is used, the trustees have discretion over which beneficiaries stand to gain, when they benefit and to what extent. If a bare trust is used then the beneficiaries cannot be changed.
Inheritance tax and pensions
Beyond supporting you through retirement, your pension can also be a tax-efficient method of transferring wealth to your loved ones. In most cases defined contributions to a private pension are classed as separate from a person’s estate and therefore avoid IHT liability.
However, this is not always the case and factors such as the age at which the policy-holder dies, the type of pension chosen and who they choose to nominate as a beneficiary must also be taken into account.
If the policy-holder dies before the age of 75, for instance, their beneficiaries will likely avoid paying IHT when withdrawing money from the pension. There is no limit as to the number of beneficiaries of a pension. If the policy-holder dies after the age of 75 then their beneficiaries will be due to pay income tax on any funds withdrawn at their marginal rate.
It is important to note that an inherited pension does not count towards the beneficiary’s own lifetime allowance (LTA). This is very useful when you consider that the LTA is currently set at £1,073,100, with any excess above this taxed at up to 55%.
Investments and business relief
If you own a business or have invested within one, you may be able to benefit from business relief (BR). This allows certain business assets to be passed on to your beneficiaries with a significant reduction in inheritance tax.
You may be able to receive 100% BR on your business or shares in an unlisted company. You may also receive 50% BR on land, buildings, machinery or shares controlling more than 50% of voting rights in a listed company.
Remember that business relief is only available where assets are deemed ‘qualifying assets’ and have been held for a minimum period of two years. As such, investments that are held for more than a two-year period are exempt from inheritance tax.
There are several ways through which business assets and investments can be accessed, namely Enterprise Investment Schemes (EIS) and private investment portfolios. However, please note that there is a higher level of risk associated with EIS and BR portfolios and it is essential that you discuss this thoroughly with an expert to understand the potential implications involved with this route of transferring wealth.
Planning for your family’s future
No matter the size or structure of your estate, having a clear plan is the key to maximising your wealth and reducing the inheritance tax bill your family would otherwise be due to pay. If you’re starting to think about your own estate or wish to delve further into your options, Gerald Edelman’s Inheritance Tax team is here to help.
Get in touch with one of our friendly experts today for a free consultation to talk through your situation and get a clearer idea of how best to protect your wealth for decades to come.