The Conservatives may be planning to take the family home out of inheritance tax (IHT), but the need for estate planning is still essential for individuals hoping to dodge the death tax.
The shock Conservative election victory will be welcomed by those with homes worth up to £1 million, thanks to changes the party have planned for IHT.
Currently, everyone can pass on assets of up to £325,000 before 40 per cent IHT is paid; this threshold is known as the nil rate band. Under the new plans, each homeowner would be given an extra nil rate band of £175,000, which would only apply to main residences.
This means that individuals would be able to pass on a home of £500,000 tax-free and a couple would be able to pass on a home of £1 million.
Spouses and civil partners inherit assets from one another free of IHT and surviving spouses also inherit the nil rate band of the deceased spouse; thus on the second death, a nil rate band of £1 million would be applied and properties worth up to this amount would not be subject to IHT.
There has already been criticism of the Conservative plan, which has been deemed confusing and only of benefit to those living in London and the South East, who are more likely to benefit from the £1 million threshold as property prices are higher.
Scott Gallacher, chartered financial planner at advice firm Rowley Turton in Leicester, says: 'It is probably the least well thought-out tax policy in a while - and there have been a lot of them. This is a skewed policy. In London it is useful, but in Leicester the house prices range from £150,000 to £500,000.'
Gallacher points out that it will affect older people who want to downsize their home. 'If you have a situation where you have a person in a £1 million home, which is outside of IHT, who wants to downsize, and they move to a £500,000 home and have a lot of cash in the bank, that cash will be subject to IHT and taxed at 40 per cent [above the nil rate band], when they die,' he explains.
He believes that the additional band should be applied to all assets and not just your home. The fact the additional nil rate band can only be applied to property means those with substantial other assets, such as savings and investments, will still need to consider their tax position carefully.
Julian Sunley, founder of Sunley Financial in Hampshire, says estate planning is synonymous with setting up complicated and costly trusts and offshore accounts - but that reducing IHT does not have to be difficult, or expensive. So what are your options?
REDUCING YOUR ESTATE
Trusts are set up to ringfence pots of cash outside of an estate, often for family reasons as well as IHT purposes; depending on the type of trust chosen, different levels of control can be used to direct the money to different beneficiaries at different times, even after the benefactor's death.
A trust might be used, for example, to ensure money does not go to an unruly son automatically at 18, but only when the trustees consider he is mature enough to use it responsibly.
But those concerned about IHT liability on their estates do not have to set up trusts; there are far easier ways to pass money on without the taxman taking a chunk.
Sunley says the best way to reduce a future IHT bill for loved ones is to 'spend the money', explaining that spending £20,000 'on a sports car' would only actually deprive your family of £12,000 after IHT is taken into account.
However, if you want to pass on more rather than less money, and you're confident you will not need it at some point down the line (for long-term care, for instance), then gifting in life is the first port of call. 'If you have money to gift, why would you pay the fees associated with setting up trusts?' says Sunley.
The new rules that allow Isas to invest in shares on the Alternative Investment Market (Aim) mean that more people can use the business property relief (BPR) rules to help mitigate IHT.
Investments that fall under the BPR rules, including Aim shares, enterprise investment schemes, seed enterprise investment schemes and venture capital trusts, cease to count as part of your estate for IHT calculations after two years of ownership (providing you continue to hold them until death).
This means a significant amount of money can be moved out of the estate, but investors wishing to do so must realise that the trade-off for the tax perk is the increased risk of investing. All of these schemes invest in small and start-up businesses, meaning there is more likelihood of losing money.
Gallacher says: 'In light of the recent changes to allow Isas to hold Aim shares, I advised one client that while this would increase the risk significantly, it would also have the advantage that after two years the value of the portfolio would be exempt from IHT. As the client's Isa portfolio was valued at £157,800, this would give a potential IHT saving of more than £63,000 after two years.'
Duncan Glassey, founder of Wealthflow LLP in Edinburgh, says individuals looking at estate planning often overlook the basics. For those facing an IHT liability, the easiest and most obvious solution may be to take out a life insurance policy to cover the tax bill. Life insurance policies can be set up by couples to pay out on the second death and cover the IHT.
Glassey says a very wealthy couple facing a large IHT bill may 'pay £10,000 a year for the policy, but it could pay out £500,000... even if they live for another 20 or 25 years; if you do the maths, they pay out £200,000 or £250,000 total but still get £500,000'.
He adds: 'Sometimes people forget the basics. With a life insurance policy you can bet against the actuaries. On the second death it means the kids get a legacy and you don't need a fancy trust or to pay huge fees to a solicitor.'
Sunley agrees that life insurance is a good way to mitigate IHT for those in their 50s who are still young enough to get a good deal on their cover - but warns that the older a person gets, the more expensive the cover becomes.
'Life cover is good for younger people, those who are maybe 55 and not in retirement. They do not know what they can afford to give away as gifts yet and they are in good health,' he says. 'When you get into your 70s, that may be when you know you do not need the money but will probably live seven more years, so then you gift.'
The pension freedom rules have also made pensions an attractive IHT planning vehicle, as savings in a pension are exempt from the tax. However, pension money may be subject to another death tax under death benefit rules, depending on whom the money is left to and when the death occurs.
A person who dies aged over 75 can leave their pension pot to whomever they like and a 45 per cent tax is levied on the money (down from 55 per cent before the pension freedoms were introduced in April). However, that rate is likely to reduce further after April 2016, when the tax paid will be linked to the beneficiary's income tax rate.
If the person who dies is aged under 75, the pension pot is passed on tax-free.
For those wealthy enough to be able to fund their retirement through savings and investments outside their pension, their pension is therefore a useful tax planning tool. Dave Harris of equity release provider More2Life, says pensions are no longer the first port of call for funding retirement, thanks to the ability to pass them on.
'It is not a case of looking at the pension first and exhausting it as fast as you can,' he comments. 'People who have saved substantial amounts in their pension pot will access [other] wealth first, because it is better from a tax planning perspective.'
WHAT YOU CAN GIVE FREE OF IHT, AND TO WHOM
There are a number of gifts that can be made to family or friends to reduce the value of your estate immediately, but there are limits. Each year you can give:
- A maximum of £250 to any one person;
- A total maximum of £3,000 in gifts to others;
- A wedding gift of up to £5,000 to your child and their partner;
- A wedding gift of up to £2,500 to your grandchild and their partner;
- A wedding gift of up to £1,000 to anyone else.
Any value of gifts out of regular income, rather than savings or investments, can be given to loved ones, but you must keep a formal record in order to ensure they are not counted as one-off gifts that could then be brought into IHT.
If you want to give larger gifts to children or grandchildren, such as a deposit for a property, they will only fall outside of IHT if you survive seven years after the gift is given.
These are known as 'potentially exempt transfers' and can help move substantial amounts out of an estate as long as you live long enough. 'If you can afford to give the money... and it will not be detrimental to you personally, then gift it,' says Sunley.