Estate Planning – What Next?

 

You’ve done everything you need to do to make sure that your affairs are handled as you would wish.  You’ve drafted a will and thought about your bequests and final wishes.  You’ve set up Lasting Powers of Attorney in case you lose capacity.  So the question that comes to mind is “What Next?”  What do you need to do, and when do you need to do it?  That’s what I will try to answer in this article, at least from a financial planning perspective.

 

Starting Position – Do Nothing

 

When it comes to reducing inheritance tax, it is important to remember that this is not mandatory.  You can choose to do nothing and to allow the inheritance tax to be paid by your estate in full, and that is your right.  No-one will ever force you to implement inheritance tax saving strategies, unless you have a very domineering family.

 

If you do nothing, it is useful to remind yourself what this means.  Inheritance tax is usually a flat tax of 40% over a threshold, which is usually £325,000 per person, increasing to £500,000 if a) the total estate in question is under £2 million and b) part of the estate includes a main residence or the proceeds of a main residence passing to a descendant.  This means that for a husband and wife, up to £1 million falls within the exemption.  After that, the full 40% tax applies, so a joint estate of £1.5 million would attract a tax of £200,000 (more if a main residence is not passing to a descendant). 

 

Importantly, pensions do not currently contribute to inheritance tax, but there are plans in the works for this to change in the next couple of years, so it is worth assuming that any value you have accumulated in a pension might also be subject to inheritance tax.

 

Option 1 – Skiing

 

I am not  necessarily suggesting going on a winter holiday here, but rather using the acronym “Spend the Kids’ Inheritance”.  Money you spend on yourself is immediately exempt from inheritance tax, so if you are in a position where you expect tax to be due, everything you spend on yourself is essentially subject to tax relief of 40%, a hefty discount for experiences you might otherwise miss out on.

 

You can of course invite your children and other heirs to accompany you on your experiences.  Whilst this is technically a gift to them, it is not something I have ever seen actually added to an inheritance tax return, potentially because there is a statutory gift allowance and it is rare to exceed this in this manner.

 

Importantly, your money is yours, so you should feel comfortable spending on yourself.  Your heirs will still benefit from anything left over, so spend away, if you can afford it.

 

Option 2 – Gifting

 

Gifts in the UK are quite strange from a tax perspective.  There is no specific gift tax, so gifts are handled under inheritance tax.  For practical purposes, this means that gifts made within 7 years of the date of death are considered to be part of the estate for calculation of inheritance tax unless one of the statutory allowances applies.  These are generally quite minor – a £3,000 annual gift allowance, a limitless number of unconnected £250 allowances, additional gifts in respect of a wedding and an unlimited habitual pattern of gifts from excess income.

 

Beyond that, a gift to a person is almost always Potentially Exempt.  This means that at the point of the transfer, no tax is due, and if the donor survives for 7 years after making the gift, the exemption is confirmed and the gift is permanently free of inheritance tax.  If the donor dies within that 7 year term, the gift is deducted from their remaining Nil Rate Band.  This means that if you make a potentially exempt gift of £100,000 and die in 4 years, your Nil Rate Band would be reduced from £325,000 to £225,000.

 

There is a form of tapering for gifts made between 3 and 7 years, but this only applies if the Nil Rate Band has already been fully utilised, meaning the cumulative gifts must be greater than £325,000.  As you can imagine, this is fairly rare.

 

A different form of tax applies to gifts made to trusts.  These are referred to as Chargeable Lifetime Transfers, and they attract an up-front payment of half of the applicable inheritance tax rate once the Nil Rate Band has been exceeded.  Again, this is quite rare.

 

When you make a gift, it is possible to insure against the inheritance tax liability that occurs if you die within 7 years.  This is usually achieved with a Level Term Assurance policy, meaning the cover is typically very cheap, but essentially makes the gift effective for inheritance tax purposes from day 1 rather than year 7.

 

Option 3 – Loans

 

If you aren’t ready to give away capital, either because you might need the money yourself or because you have concerns over what might be done with the money, you can instead make a loan. Normally this is constructed as a zero-interest loan (to avoid having to pay income tax on the interest) and repayable on demand.  This has no immediate benefit for inheritance tax purposes, as the cash value that was in your estate has now been replaced by a loan of identical value.

 

The true purpose of these strategies starts to become clear when the loan recipient does something with the assets.  For example, if you loan your children £500,000 and they buy a property with that, they might see some capital gains.  Let’s assume that the property doubles in value – it might be 10 or 20 years later, but that’s likely to happen eventually.  What is the current situation?

 

Well, you still have a loan owed to you of £500,000.  The fact that the property the loan bought is now worth £1 million is immaterial.  That means the £500,000 growth is outside your estate, potentially saving £200,000 of inheritance tax.

 

Loans can also be made into trust if you are not yet ready for your heirs to invest the loan freely.  This has the benefit of growing your assets outside your estate, with the growth earmarked for payment to your beneficiaries.

 

Option 4 – Exempt Assets

Some assets are subject to reduced inheritance tax rates.  These are generally agricultural property and business property.  Agricultural property covers working farmland and buildings, while business relief covers unquoted companies.  There is now a limit on the maximum holding size that can be exempted in this way of £1 million per person, for a saving of £200,000.

 

Assets exempt in this way generally need to have been held for a cumulative 2 years in the last 5 prior to death, which means the exemption can be obtained much quicker than gifting assets, which requires 7 years to be effective.

 

AIM shares used to be considered unquoted for the purpose of business relief, but are now subject to their own categorisation that still involves a tax rate of 20% - still a saving, but nowhere near as good as it used to be.

Option 5 – Insurance

 

I already mentioned the possibility of insuring against untimely death when making a gift, but the principle can be extended further.  You can take out a Whole of Life insurance policy designed to pay out the value of your inheritance tax on your whole estate whenever you die, and these can be very cost-effective, especially if you apply when relatively young (generally under 65).

 

You might think that this approach would be prohibitively expensive because death is something that happens to all of us, but it is quite normal to see premiums for husband and wife of between 1% and 1.5% of the inheritance tax value.  At 1%, this means you would need to live for 100 years to pay more into the policy than you get out.  There are many reasons why this pricing oddity exists, but suffice to say, it is very real.

 

Insuring against the liability is the least contentious approach to inheritance tax planning because HMRC still gets their owed tax.  The only difference is that the tax is paid from the proceeds of an insurance policy, leaving your heirs to enjoy your estate in full.

 

What Should You Do?

The answer to this question is very firmly “it depends”.  For some people, doing nothing is likely to be the right thing, but for others a strategy to minimise or mitigate the tax might well be appropriate. Importantly, you should consider your options alongside your financial plan, meaning you must make sure that any plans you decide to implement for inheritance tax planning purposes don’t leave you destitute or risk your future financial goals.

 

Without question, you should speak to a financial planner alongside your will writer if your estate is at risk of being taxed and you wish to avoid that possibility.

 

At Aegis Financial Consulting, we work with you to come up with your financial plan, then we recommend solutions to help you achieve your objectives.  If your goal is to pass on more of your wealth to your heirs, we can help you understand your options and the costs associated with each strategy.  You can then decide how you want to proceed.

 

 

About the Author

 

Ian Rex-Hawkes is a Chartered Financial Planner running an independent financial advice company, Aegis Financial Consulting.  He has extensive experience of helping people with their finances, including those wishing to reduce their potential liability to inheritance tax.  You can read more articles by Ian on his website, including this one on “Ethical Inheritance Tax Planning”.