As welcome as the introduction of the residential nil rate band last April was, it will not put an end to inheritance challenges.
Inheritance tax (IHT) is not a problem just for the super-rich any more, with an increasing number of middleclass families finding themselves in the midst of complex tax planning to avoid paying tax on the estate when the parents die.
This is due to a combination of rising house prices and the ‘nil rate band’ (NRB) threshold – the value of your assets that will not be subject to IHT at 40 per cent – remaining frozen at £325,000 since 2009.
That combination has led to bumper tax receipts for HM Revenue & Customs; it collected a record £5.1 billion in IHT in the last financial year, up 9 per cent from £4.7 billion the year before. The figures are expected to continue to tick up, with the Office of Budget Responsibility estimating that Britons will pay £1.8 billion more in IHT over the next five years than previously expected.
Residential nil rate band
This is despite the introduction of the ‘residential nil rate band’ (RNRB) – effectively an additional IHT threshold for couples owning their own property – which in due course will allow people to pass on their family home worth up to £1 million, free of IHT.
The first phase of the RNRB came into force on 6 April, giving individuals £100,000 each of RNRB on top of their existing nil rate band. The new allowance is being phased in over four years, increasing to £125,000 in 2018/19, to £150,000 in 2019/20 and to £175,000 in 2020/21. By this point, each individual will have a £325,000 NRB plus £175,000 in RNRB, giving a total of £500,000, which for a couple creates a total tax-free threshold of £1 million.
Andy Zanelli, senior technical consultant at platform Ascentric, believes that despite the introduction of the RNRB more people will find themselves drawn into the IHT net. ‘The trend will continue, possibly at a faster rate than we have seen so far, as more and more people become inadvertent millionaires,’ he says. ‘The other factor here is the freezing of the standard NRB… which will still be in place until 2020/21 – so £325,000 for 12 years. If the standard NRB grew with inflation rather than being frozen, then it should be around £425,000 in 2020/21 anyway.’
While most people planning their IHT liability will be looking forward to the dates when the RNRB increases, there is also one other important date to know about: 8 July 2015. Although the RNRB only came into force this April, people who have sold their main residential property since this date can still offset the money they made from the sale against the new allowance. This ‘downsizing provision’ is to allow older people to move into smaller homes without losing the benefits of the RNRB.
However, there may be little encouragement to downsize into a smaller property, and the introduction of the RNRB may in reality have the opposite effect, warns Scott Gallacher, director of Rowley Turton Private Wealth Management in Leicester. ‘The RNRB arguably makes downsizing less relevant and in some cases could actually encourage some to upsize,’ he says.
He gives the example of John and Jane who downsized many years ago – before 8 July 2015 – into a £150,000 retirement apartment. If they were to die before April 2018, this would be offset against their two £100,000 RNRBs. They also have £850,000 in savings and investments so their current IHT liability would be £80,000 (£850,000 - £650,000 x 40 per cent).
How to reduce a potential IHT bill
IHT receipts may be rising but there are still myriad ways to reduce the amount of money your loved ones may have to hand over to the taxman on your death. Gifting your assets when you are still alive is the first port of call for anyone looking to reduce their IHT bill.
Everyone has an annual £3,000 gifting allowance, but if you want to gift more than this you need to survive for seven years afterwards to avoid IHT; after this time the gifts fall outside the estate. Until this seven-year period is up, the gift is known as a ‘potentially exempt transfer’.
Darren Lloyd Thomas, principal of Thomas and Thomas Finance in Pembrokeshire, says: ‘As a rule of thumb, if you can live without an asset and you are completely comfortable trusting the person you wish to gift it to, then outright gifting may be the way to go.’
However, he adds that you need to ensure you are happy to give up ownership of an asset. If you’re not happy to do this then putting a gift in trust can help retain some control, but donors will have to make a decision between saving on the tax bill and maintaining control over the assets held in the trust.
Lloyd Thomas says IHT-beneficial investments could also be used to cut a tax bill, although he warns that ‘the tax tail should never wag the investment dog’. For example, Alternative Investment Market shares fall outside of an estate for IHT purposes after you have owned them for two years.
One simple solution for those who have other sources of income to fund their retirement is to pass on their pension to their children, as pension pots are not subject to IHT. But while older people may be keen to their tax bill, Lloyd Thomas as they face the ‘dichotomy’ of ‘need to save money for later care bills and the need to give it away to stop their children ping IHT’.
He says the key to this care conundrum is to ‘plan backwards’. ‘We start by research the type of care our client fee they may require, then pricing it up against the income they currently have,’ says Lloyd Thomas. ‘We look at how we would fund that gap in a worst-case scenario and then consider IHT planning from there. But you do need be very careful about “deprivation of assets” rules when give money away just prior to entering state-funded care.’
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