Ways to Reduce Inheritance Tax
This section will introduce you to highly effective ways to mitigate (i.e. reduce) inheritance tax. It is important to get our terms right here. Tax evasion means doing illegal things to avoid paying taxes.
Whereas tax avoidance used to involve using whatever legal means you choose to reduce your current or future tax liabilities.
However, the authorities have been taking an increasingly tough line in recent years and a General Anti-Abuse Rule (GAAR) was contained within the Finance Act 2013, which sought to counter ‘tax advantages arising from tax arrangements that are abusive’.
Tax mitigation (i.e. the effect of making something bad less severe, serious, or painful) is conduct which reduces tax liabilities without ‘tax avoidance’ because it is not contrary to the intention of Parliament.
Joint home ownership
- Joint tenants – on the death of one co-owner , the property passes automatically to the other co-owner(s).
- Tenants in common – are free to dispose of their share of the property as they wish.
- Care Fees – the choice of joint tenancy or tenants in common could affect your liability for care or nursing fees in older age. Tenants in common preferred in case the spouse who is still living in the family home dies first. Their share of the property can then be left to the family and will not be taken into account by the local authority when assessing the person’s needs who is in the care home.
Pensions as part of your estate
Defined Benefit (i.e. final salary) – these schemes provide an income to you (perhaps with an income continuing to a spouse or other dependant on your death) but there is no capital to be left to anyone as part of your estate.
Defined Contribution (i.e. money purchase) – if you purchase an annuity the income will similarly die with you (or your dependant). Since 2014 it has been more widely possible to ‘draw down’ an ‘income’ from your pension pot. Any pot that remains on your death can be left free of inheritance tax to anyone you nominate. Income tax may be payable on withdrawals made by the person inheriting your pension fund if you were age 75 or over when you died.
Use of life assurance
Depending on your state of health you could consider taking out a life assurance policy. This would, of course, need to be put in trust from the outset, or the sum assured would merely add to the value of your estate on your death.
For couples, a whole of life policy on a ‘second death’ basis is suitable.
As premiums on a life assurance policy are normally paid monthly they ideally suit the ‘gifts made out of income’ exemption. As the sum assured would be paid to the trustees on your death this would be free of any liability for IHT.
OTS recommendation is to consider ensuring that death benefit payments from term life insurance are IHT free on the death of the life insured without the need for them to be written in trust.
Mr and Mrs Harris are both aged 74, are in good health, and mainly due to the value of their home they have a potential IHT bill on their estate of £500,000 when the survivor of them dies. They prefer not to downsize yet and want to keep control of their investments as they produce the income to enable them to live well and travel the world. However, they are concerned about the tax bill their children would face if they were both to die early on.
For a monthly premium of £1,306 they could set up a whole of life policy on a ‘balanced cover’ basis with guaranteed premium rates that would pay out £500,000 when the second of them died. The premiums are likely to seem very high to them but they need to consider the following table.
Whilst they could lower the premiums by choosing a ‘maximum cover’ basis this is unlikely to be suitable as the premiums would be expected to increase substantially at each review.
In the following table, for the sake of simplicity, it has been assumed that future inflation is 2.0% pa and the life cover of £500,000 and monthly premiums of £1,306 increase annually by that amount.
The benefit of such life assurance is best seen when the death of both Mr and Mrs Harris occurs in the earlier years of the policy. However, even in the later years there is still a substantial financial benefit to the family.
Use of equity release
Many people in later in life ‘downsize’ their family home and release capital which can then be given to their children or other heirs. There are, however, many reasons why moving home may not always be appropriate.
In such a situation there is still an alternative to owning the home until you die and passing 40% of part of your estate to HM Revenue & Customs.
An equity release is simply a method of taking out a mortgage on your home under special conditions. The usual income requirements are waived, you simply have to be old enough to qualify. The capital released from the home can then be given to the children.
Use of a trust
A trust is created by a ‘settlor’ who transfers assets to a trustee(s). The trustee(s) must then hold and manage the assets for the benefit of the beneficiaries.
For IHT purposes trusts enable a transfer of value to be made without asset(s) immediately passing to others. They are particularly useful where the beneficiaries are minors or where the settlor wishes to maintain some control over the assets.
There are many types of trust and these are beyond the scope of this introduction to inheritance tax.
For Inheritance Tax purposes the main trusts used are:
- Discretionary trusts – particularly useful for children or grandchildren but have lost a lot of their tax efficiency in recent years. However, they are still very popular especially for holding life assurance policies.
- Discounted gift trusts – enable the settlor to receive a fixed income but have little value unless the settlor dies early on because of the accumulating income that will have been repaid to the settlor.
- Loan trusts – enables the growth within the trust to be free of IHT. However it can take a long time to build up funds out of the settlor’s estate. A combined gift and loan trust can be used to overcome this problem.
- Life interest trusts – where a beneficiary receives the income only during their lifetime and other beneficiaries inherit the assets on his or her death.
Business Property Relief
By investing in unlisted trading companies or those listed on the Alternative Investment Market (AIM), investors can qualify for business property relief (BPR). These are, of course, high risk investments.
Shares in a BPR-qualifying company become exempt from IHT after being held for just two years if they are still held at the time of death.
Unlike with an outright gift, the investor retains control over the investment, can receive a dividend income stream and can sell the investment and get the proceeds back if they need to, although they will then no longer qualify for IHT exemption.
Lasting Power of Attorney (LPA)
A Lasting Power of Attorney is a special form of Power of Attorney in that it remains valid after somebody has become mentally incapable of managing their own affairs, whereas an ordinary Power of Attorney would cease at that point.
It is important to note that attorneys are prohibited from making IHT arrangements without the specific authority of the Court. In reality in most cases it has proved that such an extension of their powers will not be granted for the gifting of large parts of the estate or placing assets in trust.
If the intended gift in any year is under £15,000 the application to the Court can be in the form of a letter. This underlines the fact that although inheritance tax is in many ways a voluntary tax, you have to start taking the necessary action early enough.
One area where an attorney can act to reduce inheritance tax on an estate is to invest part of the donor’s money in AIM Stocks. However, it would be extremely difficult to provide such advice in a compliant way, taking into account not just the attorney’s attitude to risk but that of the donor before he or she lost their capacity to handle their financial affairs.
Individual Savings Account (ISA)
ISAs are not tax free – they are certainly free of income tax and capital gains tax but they can still suffer inheritance tax.
With many people building up hundreds of thousands of pounds in ISA accounts the prospect of losing up to 40% of their value on death is very real. This is especially so now that a surviving spouse can effectively add the deceased spouse’s ISA account to theirs.
AIM ISAs – one way to mitigate the problem in later life is to switch the cash or investments within the ISA account into BPR-qualifying companies on AIM. They will then be free of inheritance tax after just two years.
Links to more information
- Inheritance tax
- Unsure about Inheritance Tax?
- Gifts to reduce Inheritance Tax
- How to calculate Inheritance Tax
- The family home in Inheritance Tax planning
- Will and Lasting Power of Attorney
- HMRC notes on Inheritance Tax
- If you need personal financial advice on Inheritance Tax then I am happy to introduce you to Flying Colours Life who have access to independent financial advisers throughout the UK
This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.
Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.
If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.