Intergenerational Wealth Planning
As the old saying goes, the only things certain in life are death and taxes. Then, to rub salt into the wound, there’s a system in place that taxes us even further in death. Welcome, ladies and gentlemen, to the thorny issue of inheritance tax.
What is Inheritance Tax?
Put simply, inheritance tax (IHT) applies to anything you leave behind above £325,000. The current rate is 40% and covers any savings, property, investments, insurance pay-outs and even vehicles that make up your estate.
It’s a controversial tax because it effectively means that your loved ones will get less than two-thirds of whatever you leave them above the £325,000 threshold. That’s from an estate made up of things that you’ve already paid tax on during your lifetime.
It’s big business for the government, who last year pocketed £5.4 billion through IHT1.
And thanks to years of rocketing house prices, that figure looks set to reach almost £7bn by 20242 as homeowners with otherwise modest estates are unwittingly caught above the IHT threshold.
But what if I told you that inheritance tax is one that’s entirely optional? In fact, there are many legal ways to avoid it, with a bit of forward-planning.
Work out what you’re worth
Few of us want to focus our energy on what happens to our wealth when we die, but ignoring it can be a costly mistake. As I mentioned earlier, death is one of the few things in life that we know we’ve got coming. If you have assets, they will inevitably pass to someone else when you go.
The first thing to do is familiarise yourself with the current rules. We know that the first £325,000 of an estate is exempt from inheritance tax. Or, to use Treasury-speak, falls into the nil-rate tax band.
What you may not know is that, if your estate is worth less than £2m and includes your main residence, your tax-free limit increases by a further £150,000. This takes the total tax-free amount you can leave behind to £475,000.
The icing on the cake is that it’s an individual allowance, so married couples and those in civil partnerships can leave up to £950,000 before IHT is payable.
Next, make a plan
As anything in your estate above this nil-rate band will be taxed at 40%, your next move should be to work out how much more there is. Only then can you figure out the best way to use it now, so it doesn’t get taxed later.
The very first step is to ensure you have a valid Will in place to make sure your wishes are known. After this, we then need to look at how we can reduce the IHT bill!
Happily you have a number of options:
- Spend it!
Money should be spent! You’re either spending it now or saving it to spend at a later date. As you’ve already paid income tax on it, why leave it behind only for it to be taxed again?
The only thing you need to be sure of is that you have enough money to last your lifetime. This kind of future-proofing is where guidance from a financial planner is worth its weight in gold.
- Be generous!
Why wait until you die to give the kids their inheritance? This is a common sentiment among Baby Boomers who are increasingly acting as the Bank of Mum and Dad.
Unfortunately, gifting your money while you’re alive is a bit more complicated than it sounds, so it’s a good idea to get professional advice.
As a rough guide, you can avoid inheritance tax by:
- Giving £3,000 worth of gifts away a year
- Giving unlimited gifts less than £250 (as long as it’s not the same person you gave £3k to). You could make everyone’s birthdays more fun!
- Being generous with wedding gifts. You can hand your child £5,000 and your grandchild (or great-grandchild) £2,500 to mark their big day. The limit for wedding gifts for any other relatives or friends is £1,000.
- Helping a former spouse, an elderly dependent or child under 18 in full-time education with living costs
- Giving gifts from your income, rather than savings. Inheritance tax is payable on your assets, so gifts made directly from a salary, or a pension, are exempt if they are regular payments.
- Pay your grandchildren’s school fees
Anything outside of these exemptions would be classed as either a Potentially Exempt Transfer or a Chargeable Lifetime Transfer (CLT) and could still be counted as part of your estate if you die within seven years of making the gift. So choose wisely in your benevolence if you’re looking to reduce the overall IHT bill.
In particular a CLT would have an immediate charge of 20% on the value of the gift.
So, whereas gifting the money away seems logical there are many landmines to avoid and professional guidance should be considered.
- Donate to charity
Anything you gift to a charity, museum, university or community (amateur) sports club is exempt from tax. Gifts to political parties are tax free if the party meets certain conditions.
So again, choose wisely.
- Gift your pension
Thanks to new ‘pensions freedom’ rules introduced in 2015, any money in a pension fund that hasn’t been used to purchase an annuity can be left to the next generation, free from inheritance tax.
There is, however, a chance that your beneficiaries will have to pay income tax on it. It also doesn’t apply to final salary pensions.
- Life insurance
This doesn’t reduce inheritance tax but it can be a good way to pay for it. As long as you work with an advisor to figure out your likely IHT bill while you’re still alive, you can find an insurance policy that will pay out the sum to cover it upon your death.
It’s crucial, however, that the policy is placed in trust to avoid the pay-out being added to the estate and itself made liable for IHT.
This is a slightly more complex way of gifting your assets whereby you set up a trust detailing how much you want to give away now, who you’re giving it to and when they are to receive it (i.e. at a certain age, or upon your death).
As the trustee, you can also place restrictions on what the money can be used for, so it allows for a little more control over the money, rather than if it was gifted outright. Be warned though – you can’t use it for yourself or the trust will fail.
The complexities of trusts is an article in itself, so all I’ll say for now is that professional advice is vital if you’re tempted down this route.
- Use Business Relief
Business Relief is designed so family businesses can pass through the generations without being ravaged by IHT. But not many people realise that it also extends to unquoted shares.
This effectively means that it’s possible to have an investment where, as long as certain conditions are met (e.g. they must be held for a minimum period of 2 years), they won’t be counted as part of your estate, so won’t be subject to IHT.
This is a route growing in popularity as it allows you to retain access and control of the money for your own benefit, rather than giving it away. But, as the conditions are quite specific, it’s an area where professional guidance is necessary.
As you can see, there are many ways to avoid – or at least reduce – the burden of inheritance tax, but few are straightforward and all require a degree of financial planning.
For most of us there isn’t a one-size-fits-all approach, so working with a knowledgeable financial adviser is the best way to make the most of the above strategies.
And don’t forget that estate planning isn’t just about preparing the money for the kids.
It’s also about preparing the kids for the money.
Involving them in a conversation about their inheritance is the best way to make sure your wealth passes between the generations in the most efficient and effective way possible.
All information correct at time of publishing in July 2019
1 HMRC Tax & NIC Receipts, Apr 2019
2 HM Treasury Budget Autumn 2018