Independent Financial Advisors - IFA Bolton, UK

FIRST STEP

The first step to any Inheritance Tax (IHT) plan is to ascertain what your current IHT liability would be. You might not be aware that some of the investments and insurance policies that you already own could afford significant IHT benefits. For example, a Chartered Financial Planner professional will be able to help you ensure that the death benefits from your pensions and life assurance policies are written in trust so that the benefits do not automatically fall into your estate on death.

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HOW IS YOUR ESTATE DISTRIBUTED ON DEATH?

Please see HMRC Direct Gov Site

Since 9 October 2007 individuals have been able to offset any unused nil rate band (NRB) on their spouse’s previous death against their own estate in addition to their personal NRB. These rules allow a surviving spouse or civil partner to use any NRB that their spouse, or civil partner, did not use against their inheritance tax estate, in addition to their own NRB.

Make use of Allowances and Exemptions

We all have a number of allowances that we can make use of to reduce our IHT liability. First, there is the £3,000 annual gift allowance per donor. This can also be backdated one year if it has not already been used. We can then make use of our small gifts exemption by passing £250 per annum to any number of different donees. In addition, we can gift £5,000 to a child and £2,500 to a grandchild as a wedding present. Finally, any gifts out of income that are ‘regular and habitual’ are also free of IHT.

Potentially Exempt Transfers (PETs)

In addition to the above allowances, we can give away larger sums which will reduce the value of our chargeable estates on death, as long as we survive for a period of 3 years after the gift. If we survive for 7 years, the full value of the PET will have fallen outside of our estate. Taper relief reduces the IHT payable between years 3 and 7 as demonstrated in the table below:

There is also a common misconception that PETs have to involve some sort of fancy, expensive financial product. Investment bonds and trusts are only really required where you as the donor wish to retain some form of control over how the money is invested and when your chosen beneficiary ultimately receives it. From 23^rd March 2006 many gifts to trust that would previously have been treated as PETs will now be treated as Chargeable Lifetime Transfers.

In many cases it is better for both donor and donee if the gift is made by cheque so that it can be used as the donor and donee want. Many grandparents like to see their gifts used to provide for their grandchildren’s education for example. The IHT that would be payable if death occurs during the seven year period can be protected quite cheaply by taking out a short-term life assurance policy.

Chargeable Lifetime Transfers

The Finance (no 2) Bill 2006, published on 7th April 2006, was designed to “align” the IHT rules for trusts, broadly bringing most interest in possession (IIP) and accumulation & maintenance (A & M) trusts into line with the existing regime for discretionary trusts.

The new rules will not apply in the following circumstances:

· Trusts created on the death of a parent for their minor children who become absolutely entitled to the assets of the trust at 18.

· Trusts created for disabled people

· Trusts created on death for the benefit of one person who has a life interest and whose interest cannot be replaced.

The changes apply to existing IIP and A & M trusts, subject to transitional rules.

The rules mean that:

· Transfers to relevant property trusts will be treated as chargeable lifetime transfers (CLTs), so that an immediate IHT charge of 20% (30% from 6th April 2010) will be payable where the settlor’s available amount of Nil Rate Band (NRB - £325,000 for 2009/2010 tax year) is exceeded.

· A periodic charge of up to 6% on the value of trust assets over the IHT NRB at each 10 year anniversary.

· An exit charge proportionate to the periodic charge when capital leaves the trust between 10 year anniversaries may be payable.

Chargeable Lifetime Transfers will continue to represent a useful way to mitigate IHT for those who wish to retain some form of control over the gift, but we would stress that careful planning is required.

Insurance Solutions

Once you have written your Will and committed to a long-term gifting plan, you might need to start looking at other ways to mitigate your IHT liability.

Any IHT liability can be fully covered by a whole of life insurance policy. The intention of such a policy would be to pay the IHT bill on your death and by placing this policy in trust, not only would it fall outside of your estate on death but the trustees would not need to wait for a grant of probate before releasing the proceeds.

Whole of life insurance can often seem expensive when compared to other types of cover such as term assurance. The reason for this is that the insurance has a definite risk – you will die at some point and if you continue to pay your premiums until death, the insurance company will have to pay out the sum assured.

There are a number of types of whole of life assurance and it is important to understand the differences between them.

Standard or Balanced cover plans aims to provide a set sum assured for a fixed premium. This premium should remain constant throughout your lifetime, provided that the underlying fund grows at the pre-selected assumed growth rate, usually 6% per annum. The policy will usually have a 10 year review and then further reviews every 5 years thereafter. If the fund has not grown by the chosen percentage, either the sum assured will fall or the premium will rise. This type of policy has a high investment content and may produce a surrender value if it is encashed. A ‘projected’ surrender value after 10 years would be provided in a preliminary quotation.

The fact that the amount of cover is linked to an investment return has caused problems in the past and some insurance companies have launched guaranteed whole of life policies whereby the life assured takes no investment risk and pays a fixed premium which cannot change. This is an attractive option for many individuals.

Maximum cover will provide a specified sum assured for a much lower initial premium than standard cover but these premiums will rise significantly at the policy reviews. There will be little investment content and therefore not much in the way of a surrender value if you stop paying your premiums. The difference in premiums between Standard and Maximum cover is much higher for younger applicants than those with shorter life expectancies.

Many people who take an active interest in their investments have a ‘phobia’ against paying for life insurance. However, whole of life cover forms an essential part of most sensible IHT plans and is something that Independent Financial Advisor Ltd will discuss with you if IHT mitigation is one of your objectives.

Trusts

This is an extremely important area of life insurance that is often overlooked. If a whole of life insurance policy is being taken out as part of an inheritance tax plan, it should always be written in trust so that the benefits fall outside of the deceased’s estate.

It is often wise for term assurance policies to be written in trust too. You do not know if (or when) you are going to die during the term of the policy, nor do you know what your family’s circumstances will be at the time of your death. Your financial position might be decidedly different to what it is now.

Depending on the cause of death it could be months, or even years before probate is granted and the death benefits can be paid out. However, if the policy is written under trust, the trustees do not need to wait for a grant of probate before releasing the proceeds. In this way, the benefits can be passed directly to your family when they need it most.

Investment Solutions

Where you want to reduce your IHT liability but wish to retain control of your money, you may wish to consider a Loan Trust, Discounted Gift Scheme or portfolio of Unlisted Shares. These schemes allow you to retain some form of access to your investment whilst aiming not to fall foul of the ‘gift with reservation’ rules.

A Loan Trust may be appropriate where you wish to minimise your future IHT liability but are reluctant to relinquish control of your capital. The best way to describe the effect of a loan trust is ‘IHT freezing’ as the loan trust ensures that all future investment growth falls outside of your estate.

The settler (investor) establishes a trust for the benefit of his or her heirs and then lends the trustees a sum of money, which is immediately invested. An income would normally be required and this will take the form of loan repayments from the trust. As these loan repayments are a return of capital, no income tax is payable by the settlor.

It is normal for the underlying investment to be placed in a single premium investment bond, issued by an insurance company. These are tax-efficient for trusts as they are deemed to be ‘non income producing assets’ for tax purposes. All natural income and growth from the underlying investment is retained within the trust. Any income paid to the settlor is really a return of capital.

The investor will normally limit ‘income’ to 5% per annum for tax purposes, meaning that the full amount of the investment will fall outside of his or her estate after 20 years. At that time, the value of the investment will be made up of growth only and as we explained above, all growth falls outside of the estate.

The advantage of a loan trust over a discounted gift scheme is that the settlor can call in the full value of the loan at any time. The disadvantage is that it takes much longer to get the full amount outside of one’s estate.

A Discounted Gift Scheme creates an immediate reduction (the discount) in the taxable value of your estate whilst allowing regular ‘income’ to be taken for the rest of your life. As with the loan trust, we have used inverted commas as the ‘income’ is really a return of capital, not natural investment income.

The investment amount is notionally split into two distinct parts for the calculation of IHT. The discount will be the total amount of withdrawals that someone of your age, sex and health would be expected to receive back into their estate as ‘income’ during the course of their lifetime. Withdrawals of anything up to 10% per annum can normally be taken, although 5% per annum is the norm. This ‘income’ is fixed at the outset and cannot be changed. It is only access that the settlor has to the investment.

Detailed in the below tables is an estimate of the discount available based on a single life investing £100,000, taking level annual withdrawals:

Discounted gift schemes are most appropriate for people who do not have a long enough life expectancy to benefit from loan trusts and still require an income from their investment. Investors should remember that the ‘income’ is the only access that they have to their original capital.

Unlisted shares such as Alternative Investment Market (AIM) and Enterprise Investment Scheme (EIS) portfolios fall outside of the estate on death if held for a minimum of two years. Such investments carry significant risk but can form an integral part of a disciplined IHT plan.

Under legislation introduced in 1996 any money which is invested into qualifying AIM listed companies and held for more than 2 years at the date of death is exempt from Inheritance Tax.

The problem with the AIM stock market is that it is very volatile, there are some providers, such as Octopus Investments, who offer a secure fund which is designed to deliver a return (after charges) of 3% per annum. If the annual return does not reach this level the provider will contribute up to the 3% to make up the shortfall. The annual return on the investment can either be re-invested back into the investment or taken as an annual income payment.

By investing in this kind of scheme you do not have to wait up to seven years and loose control of your assets in order for the IHT liability to be reduced. Instead you will only need to wait 2 years in order to mitigate IHT and at the same time retain control of your assets and receive an income from the investment.

If you have a very elderly relative with an IHT problem and he or she holds stock portfolios or other equity investments on a ‘growth’ mandate, would an AIM portfolio be any higher in risk? The answer is maybe not, particularly as the existing portfolio and any growth will be taxed at 40% on death.