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Beginners Guide to Inheritance Tax (IHT) – Part 2
In part 1 we looked at what Inheritance Tax is and some basic allowances. Here, in part 2 we will outline some basic steps to consider to help reduce your IHT bill. You should note that with some of these steps it is important to plan ahead.
Step 1 – Basics
Make sure you have a will and it is kept up to date on a regular basis. If you die without a will (intestate), your estate will be distributed according to the rules of intestacy. Whilst in some cases this may still result in all assets going to a spouse, it is very important if you are not married, as ‘common law’ partners and co-habitors are not covered by intestacy rules and therefore in these cases you would not receive any of the deceased’s capital or even potentially their share of your house.
The laws of intestacy vary depending upon whether you live in Northern Ireland, Scotland, England or Wales. However in principal a spouse will be entitled to an amount of the estate with an entitlement to a life interest in a proportion of the remainder with the balance going to children when they are 18 or older. If you have no spouse it may be passed to your parents or then your siblings. If you have no recognised family, it will go straight to the Crown. We have seen recent TV programmes trying to trace distant relatives of estates, which have gone to the Crown. Some of these can be very substantial so don’t think this could only happen to small estates.
Step 2 – Use the Allowances
We outlined the basic types of allowances in part 1. Using these on an annual basis will help plan for the future and will establish a pattern of giving which is needed to be able to claim the regular gifts from income allowance. Unfortunately many people only think of IHT whenever they have already fallen ill. This leaves your options fairly limited. It is better to plan ahead, as we have seen a gift treated as a PET will take 7 years to fall outside of your estate. Therefore it is much better to plan and make these gifts whenever you are still in good health and likely to live another 7 years.
Step 3 – Using Trusts
Trusts have been used for many years to help mitigate IHT. They were used so effectively that in the Budget of 2006, the then Chancellor moved to change how many trusts were treated in an attempt to reduce their effectiveness.
Most transfers into trust over the NRB are now having to pay an upfront 20% IHT charge. The 20% is based upon being half of the death rate so clearly if the death rate changes this rate will also change. In addition to this the trusts are liable to periodic charges of up to 6% every 10 years and an exit charge when funds are taken.
These tax charges may sound punitive, however they only apply if the gift into trust is above the NRB (or twice the NRB if married). Therefore they can be very effective trusts for gifts below this amount and there are also some tax planning ideas that can help eliminate the periodic charges. In addition to this and whether or not the gift is over or below the NRB, they also allow for the ‘regeneration’ of the NRB every seven years. This happens as the gift falls out of the calculation after 7 years and therefore you could use your NRB again. This is why as have previously stressed it is important to plan early.
Step 4 – Use Life Assurance
If your estate is mainly made up of illiquid assets or you just don’t want to make gifts into trust and loose access to your capital, you may find using a life assurance policy an effective way to pay your IHT bill and still leave your estate to your children. Any life assurance policy should be written into trust otherwise the payout on death would just be added to your estate making the IHT problem bigger. If the premiums are payable at least annually then these could be funded from regular income as part of a pattern of giving and therefore there is no IHT consequence on payment of premium.
An added benefit of this method is that the proceeds of the life assurance policy will be paid out quickly, probably before the estate itself is being unwound.
The main disadvantage of placing assets into trust is normally you have no access to the fund. One scheme that helps reduce IHT and still provides income from the capital is a Discounted Gift Trust.
This is essentially an investment bond placed into a trust. However the rules allow the trust to pay an income to you for the rest of your life. As a result of this part of the value being placed into trust is discounted at outset (ie the value of the future income based upon your age and typical life expectancy). This is outside your estate day one of the investment, with the balance, the ‘gift’, taking 7 years to fall outside the estate. The income will continue to be paid for the rest of your life even if this is beyond the 7 years. It is important however that you spend the income otherwise you simply accumulate it back within your estate which would defeat the object of the investment in the first place.
Most investments, including ISA’s are subject to IHT on death. However some, for example Enterprise Investment Schemes (EIS) can qualify for an IHT relief at 100% if owned for more than 2 years. However most EIS’s are deemed high risk investments. This is due to the fact that they qualify for Business Property Relief (BPR) after 2 years. There are a variety of BPR products available some of which are lower risk which we can talk to you about.
Finally if you own farmland this could qualify for agricultural property relief which is again something we can advise you on.
Chartered Financial Planner