Inheritance Tax (IHT) was once a tax deemed to be paid by only the wealthy. However, more and more of us are being affected by IHT-that is, having to pay 40% tax on your estate if it exceeds a certain amount. The reality is that many people can take steps to mitigate much of this tax and in some cases, with the right advice taken, not pay any Inheritance Tax at all.
What is Inheritance Tax?
If your estate is worth more than £325,000 (Nil Rate Band for a single individual) or £650,000 (Nil Rate Band for married couples/civil partnerships), your beneficiaries will be taxed at 40% on anything above that figure. Your estate is made up of cash assets, shares, the value of your property and its contents, your car(s), life insurance policies you may have, also property that you may own in any part of the world basically, everything you own. For a lot of people, the taxman’s bite of this apple is a little too large to swallow.
Who has to pay?
All United Kingdom residents (deemed domiciled for IHT) are subject to IHT on all of their worldwide assets above their Nil Rate Band (NRB) allowance. As a general rule, if you have lived in the United Kingdom for 17 or more years out of a 20 year period then you are deemed to be domiciled.
What happens when I die?
If your estate is subject to IHT, the tax bill must normally be paid before probate can be granted. Probate is the process of legally establishing the validity of a will before a judicial authority, and until this has been granted your assets cannot be released to your beneficiaries. Your executors are legally responsible for administering the estate and therefore responsible for paying the IHT bill.
Your executors have six months from the end of the month in which death occurred to pay the tax. Payments made can be from any savings or investments that may be available within the estate. If the main assets are (as is typical) made up of property and savings or investments and are not available, then you may be able to pay the tax owed in instalments.
You can get help, but the difficulty is knowing who to ask for financial advice, some advisers fear raising the subject with their clients due to the potential complexity of the matter, sadly allowing more of your money being paid to Her Majesty’s Revenue & Customs and less to your loved ones.
Planning doesn’t have to be complex. With the proper steps taken your estate can be distributed in the most cost-effective way.
What are my assets?
As mentioned above, your assets consist of everything you own. However, there tends to be some confusion on assets that you have gifted, So let’s take a quick look at the rules regarding gifts. Gift with reservation rules, mean that if you gift an asset you can no longer benefit from it. So if you gift the house that you live in to your children, you can still live there but will have to pay them rent for living in what is now their house. In turn, they will now have to pay income tax on the rent they receive from you. This may be a solution for you, but you will have to calculate how much income tax on the rent will be paid versus IHT, to see if it is worth it. The same applies if you make use of any asset, in short if you enjoy the benefit then you will be taxed for it as if it is part of your estate. You may have a second property which could be more practical to gift. Don’t forget, for it to work you have to give up all rights to it. For instance, you could gift your holiday home but you could not use it anymore, or if you did you would have to pay for the privilege.
However, before all of this takes place, you would have had to satisfy the Potentially Exempt Transfer (PET) rules. Firstly you can give anything away just as long as it’s a true gift, as explained above. Then you must survive by seven years the date the gift was first made in order for it to fall completely outside of your estate and thereby be free from IHT. After the third year of the gift being made, it is subject to taper relief – a sliding scale of tax reduction that occurs from the third to the seventh year. It is important to note how the taper relief is applied. It does not apply for all gifts, it is in fact only on gifts that are made in excess of the NRB, and it would only be the amount above the NRB that would attract relief, i.e. if you made a gift of £400,000, only £75,000 would receive taper relief. This is because the tax is calculated in a chronological manner and any gifts you make are first applied against the NRB.
How do I plan ahead?
The first thing to do is to make a will. In your will you can make provisions for some of your allowable transfers to ensure that they are not wasted, like the £3,000 annual exemption. If you are married or in a civil partnership then this could amount to £6,000 saving £2,400 straight away!
Next would be to ensure you don’t lose your Transferable Nil Rate Band (TNRB). On the 9th October 2007, TNRB was introduced. Married couples and civil partners can transfer any unused NRB from the first deceased partner’s NRB, regardless of when death occurred. This means planning can be quite straightforward in most cases, but there are a couple of things to bear in mind.
Firstly the TNRB is not automatic, the executors of your estate have to make a claim on your behalf. However, if you have used some of your NRB in your will, they can only use the balance. For example, if you state in your will you wish to leave your children £130,000 this means you have used up some of your £325,000 NRB. This amount would equate to 40% of your NRB. So, if on second death, let’s assume that the NRB is now £400,000, then there will only be 60% of the TNRB available. Had nothing been gifted to children on first death then the whole TNRB would be available which would mean more of a tax saving potentially on second death. We say potentially as historically the NRB has been increased by the government year on year, however, recently we have seen it frozen. One would assume that we will see the NRB start to increase year on year once again at some point in the future, so it’s not bad planning to simply leave everything to your surviving spouse or civil partner, maximising the amount of TNRB. (Only, of course, if this suits your wishes).
If you remarry after your partner’s death, you are entitled to use your deceased partner’s allowance in the same way. If you have remarried somebody who was previously widowed also, you could pass on up to £1,300,000 free of IHT to your beneficiaries.
Some assets are exempt from Inheritance Tax if they are transferred during a person’s lifetime. – These include:
A transfer of £3,000 can be made each tax year. If the entire £3,000 is not used in any one tax year, the balance can be carried forward to the next tax year.
Small Gifts exemption
A gift of £250 can be made each tax year to any number of people.
Normal expenditure out of income
Gifts of a recurring nature can be made out of income so long as they do not affect the donor’s (the person making the gift) standard of living.
Marriage gifts exemption
A gift made in consideration of a marriage taking place. From a parent this can be up to £5,000; from a grandparent this can be up to £2,500 and from anyone else this can be up to £1,000.
Other exemptions that are available include: family maintenance, gifts to UK registered charities, gifts to political parties, gifts for national purposes, gifts of land to registered housing associations, heritage property, and if death occurs on active service.
Taking advice on how to use these transfers can prove worthwhile also. For instance instead of gifting £250 direct to somebody, you could instead fund a life insurance plan written in trust, typically proving to be worth much more than the £250 from day one.
When you are making use of these transfers it is important to keep an accurate record of them which should be kept in a safe place for your representatives to deal with after your demise.
Certain assets held at death can receive up to 100% relief from Inheritance Tax. These include the following:
Business property relief is a relief for transfers of business property. It is dependent on a number of factors, the main one being that you have owned the business property for two years or more. For example, if a sole trader dies and leaves his business worth, say £2 million to his son, there is no IHT to pay. This would enable the family business to be preserved intact down through the generations. The relief is available for transfers in life and death.
You can claim 100% IHT relief for any agricultural property, provided that the following applies: the property must have been occupied by the transferor for over two years and used for agricultural purposes, or owned and let out by the transferor for seven years for agricultural purposes.
You can claim 100% IHT relief for the value of any trees, but not the value of the land on which they stand.
If you can afford to give an asset away entirely but wish to maintain some control of the asset, you may wish to consider the use of trusts.
A trust can be used in order to transfer assets, typically a second home or shares, to named individuals. If the trust used is anything other than an absolute trust or a trust for a disabled person, this will be a chargeable lifetime transfer and if the amount gifted is in excess of the Nil Rate Band at the date of the transfer, tax will be payable. In seven years it falls completely outside of your estate.
Let’s look at this in a bit more detail. On the 22nd of March 2006 the way trusts were taxed changed.
These changes affected two main trusts. Accumulation and Maintenance trusts and Interest in Possession trusts.
Before these changes these trusts were classified as Potentially Exempt Transfers (PETs). This meant that you could transfer as much money as you wanted into one of these trusts, the gift would be treated as a PET and after seven years the gifted money would fall completely outside of your estate.
Following the changes in the Finance Act, these trusts were brought into alignment with the tax treatment of Discretionary trusts. These types of trusts are treated as Chargeable Lifetime Transfers. This means that there can be an entry charge on setting up one of these trusts if the gift is more than the available Nil Rate Band of up to 20% of the amount gifted.
The existing treatment of Interest in Possession trusts will remain as long as the beneficiaries, as at 22 March 2006, are not changed after 5 April 2008.
New trusts are treated as a new settlement and subject to the taxation rules under a Discretionary trust. They are then liable to a periodic tax charge of up to 6% on the value of the trust assets over the Nil Rate Band of up to 20% once every 10 years.
There are, however, exceptions to this rule for certain trusts.
Lifetime transfers into a trust for a disabled person.
Trusts created on death for a disabled person.
Trusts created on death for a minor child of the deceased to which the child will become fully entitled to the assets at age 18.
Trust created for the absolute benefit of a beneficiary.
Interest in Possession trusts created under the will of a deceased person.
What if I still need an income from or access to my money?
The good news is there are some trusts that will allow this namely, a Discounted Gift trust. This type of plan is suited to those who are less concerned with having access to their capital but require a regular income.
An individual (the settler) makes (a gift) a one-off payment into the trust. The settler then takes a regular income from the trust that is determined at the outset, based on the settler’s own requirements and affordability. The Discounted Gift trust is unique in that it can achieve a very substantial reduction in your Inheritance Tax liability as soon as the trust is set up. This is owing to the way in which the trust is set up. The reduction is dependent on your age, health and the level of income you draw from the trust. The amount is the discount achieved and on death falls outside the estate. A great way of producing an income and reducing your estate for IHT purposes all at the same time.
If you require access to the capital then you may wish to consider a Loan trust. These are designed for people who wish to reduce their potential IHT liability but still need to retain access to their capital and/or an income.
You make a loan to a trust. Once capital is placed into this trust, any growth is outside your estate. As the investment grows the IHT liability will not, so all future growth is not subject to IHT, but the original value of the loan will always be included in your estate.
How else can I prepare?
Although not a very popular option, you can pay for the tax in advance by taking life cover, which is an insurance based solution that will help your beneficiaries pay the IHT bill on your death. It provides a guaranteed lump sum on your death, which will be immediately free from IHT if placed into a suitable trust.
This guide is a basic introduction to Inheritance Tax and many of the options available to you regarding mitigation. We hope that you have a better understanding of your situation now. There are many other solutions, however it would not be practical to go into them all in detail in this guide.
*How to use your main residence without having to move out of it or to pay rent to your children for living in your own property.
*How you can gift money that will fall outside of your estate in two years and keep instant access to the capital at all times.
*Making a gift that would be worth twice as much as the amount gifted from day one, plus it falling outside of your estate for IHT purposes.
If you would like help with any of the solutions in this guide or would like more information on the other solutions not covered in detail, then please contact us and we will be happy to help.
You can call us free on 0800 023 70 70.
Good luck with your tax planning.
Thornton & Baines