As far back as 1789, Benjamin Franklin wrote a letter to Jean-Baptiste Leroy where he famously said…“in this world nothing can be said to be certain, except death and taxes”.
As both of these don’t appear to be going anywhere, even The Office of Tax Simplification (and yes, there really is one) has been conducting a review of how the Inheritance Tax (IHT) process can be improved.
No doubt this will take some time to conclude, but as there is a current spotlight on IHT, I thought I’d write something on the top ten areas of confusion, I am often asked to explain.
- Transferable nil rate band
Under the current system, introduced in 2009, the standard nil rate band is set at £325,000. However, when someone dies, their executors can claim the unused nil rate band form any spouse or civil partner who passed away before them. So this could mean that the deceased’s estate can climb to £625,000 before IHT is applied.
The amount you are allowed to utilise from former partners will be reduced if gifts were made to the partner, or other people, in the 7 years prior to their death. This in itself can be complex, as copies of original wills and grants of probate will be required to determine the gifts made, when claiming the allowance of a former partner.
- Residence Nil Rate Band (RNRB)
As things currently stand, there is an extra £125,000 (rising to £175,000 by 2020/21) nil rate band available when the family home passes to direct descendants. However if you don’t have children or grandchildren, then you cannot take advantage of this. Estates valued over £2 million can also lose all or part of this allowance.
If you have downsized, or sold your home to pay for residential care, or moved in with relatives, then you can still benefit from RNRB, despite the fact that there isn’t a physical property that is passing to your direct descendants. Just watch out for the complex adjustment calculations though, as they can be particularly complicated when a number of beneficiaries are involved, especially when they are not direct descendants.
- Pensions and IHT
Most of the time any lump sum death benefits from a pension scheme will be IHT free. However, if you are in poor health and you transfer benefits to another scheme, or pay contributions, or place buy-out plans or retirement annuity contracts in trust – then this can result in IHT becoming payable.
As long as you are healthy when you make these changes, then the value transferred will be nil. HMRC will also assume someone is in normal health if they survive the above actions by 2 years.
- Lifetime gifts – who pays the tax?
Gift giving can be a successful way to help avoid IHT, however any responsibility for IHT belongs to the gift recipient. So it’s worth reminding ourselves of the different scenarios that can arise.
Any gift to a spouse or civil partner is exempt from IHT. Gifts to others are free from IHT as long as the gift giver survives for 7 years after the gift is made. If they pass away before 7 years, then the gift becomes chargeable and is added back into the estate for IHT.
Gifts made into trusts are seen as Chargeable Lifetime Transfers (CLT’s) and can be complex and worth chatting to a qualified financial adviser about, especially as they can often lead to uncertainty as to who ultimately has the potential tax liability.
- CLTs and the ’14 year rule’
If there’s one area that creates questions it’s the way that gifts impact on one another, especially how a gift made up to 14 years ago can still have an effect upon the tax paid on subsequent gifts.
As all prior CLT’s will continue to reduce the nil rate band available to chargeable transfers within the 7 years before death. This means that any recipient of a gift 7 years before death may have tax to pay due to another transfer made up to 14 years before the person passed away.
- Taper relief
Don’t fall into the trap of assuming that taper relief can reduce the value of a gift made within 7 years of a donor’s death, as it can’t. It simply reduces tax payable on the gift, but not the gift itself.
If the gift was made between 3 and 7 years before death, then taper relief is available, reducing the tax payable by 20% for each complete year from year 3 onwards.
- Gifts with reservation
To be effective for IHT, a gift must be just that – a real gift.
The donor can’t benefit from the outcome of the gift. For example if the donor continues to benefit from the gift of a property, then it will be classed as part of their estate. This means that you can’t give away your family home and continue to live there, unless you pay the full market rent to stay, or only part of the property is gifted and the co-owners share the running costs.
- Normal expenditure out of income
Regular gifts made out of surplus income are immediately exempt from IHT.
But what counts as income isn’t the same as taxable income and it’s well worth having a conversation with your financial adviser to fully understand the definition of income and to identify the opportunities available.
- Reduced rate for charitable trusts
Making any gift to charity in a will, where the gift is more than 10% of the net estate, will reduce the rate of IHT from 40% to 36%, if the will is carefully drafted to ensure the 10% test is met.
However, it’s worth noting that the amount given to the charity will always be greater than any tax saved.
- BPR – trading businesses
Business property relief (BPR) on a trading business is available for transfers of unlisted shares and the business property itself, if the property has been owned for 2 years or more prior to the transfer.
IHT can be complex – but great advice is always the best place to start.
I hope that I’ve shed some light into the complex workings of Inheritance Tax Planning. With the on-going focus upon the various aspects of IHT currently being undertaken by the Government, it may be worth consulting with your financial adviser to ensure that your IHT plans are up-to-date and conform with changes in legislation.
As always, here at Bridgewater Financial Services Ltd, we would be happy to answer any questions you may have, so please don’t hesitate to get in touch.