Ian Cowie says the simplest ways of avoiding inheritance tax are the best — especially when the law keeps changing
If there is one thing worse than paying inheritance tax, it is discovering at the graveside that an expensive IHT-avoidance scheme has proved a waste of money, in addition to what you are going to have to pay HM Revenue & Customs anyway.
A family friend had that infuriating experience recently, and many more widows — for it is usually the wife who is left to pick up the pieces — will suffer a similar fate in future. The reason is that Gordon Brown has become increasingly cavalier in making retrospective changes to legislation in ways many busy families fail to notice until it is too late.
For example, the imposition of a pre-owned assets tax (POAT) in April 2005 substantially tightened rules against gifts ‘with reservation’ — that is, where donors retain some benefit from the family home or other assets. Accountants and insurance companies had marketed a variety of schemes for this purpose — often using trusts and loans in complex structures — but POAT rendered most of them ineffective.
Similarly, the 2006 Budget created a potential income tax charge on many trusts, even on simple life assurance policies, written so that death benefits would fall outside the estate for the purposes of calculating tax. As usual, the Chancellor did not have time to mention this in his speech. Anyone who thinks they or a member of their family may have made such arrangements, perhaps as part of a will drawn up many years ago, should seek professional advice now.
Bear in mind that rising house prices have lifted many families of relatively modest means above the £285,000 nil-rate band for IHT. Because this tax applies at a fixed rate of 40 per cent, it is turning more people than ever before into top-rate taxpayers for the first time after they die. The Revenue is unable to say how many, but Halifax calculates that more than a third of the detached homes in Britain are now valuable enough to trigger IHT bills for their owners, even before any other assets are taken into account. Halifax says the threshold would need to be £430,000 to have kept pace with house-price inflation.
So you do not need to be rich to worry about this posthumous stealth tax. Some of the simplest steps to avoidance may prove the most effective because, as a general rule, the more complex your plans, the more vulnerable they may prove to attack by the Revenue — which has pursued a more aggressive approach in recent years, doubling the IHT take since 1997 to about £3.3 billion last year.
As usual with financial planning, the sooner you start, the easier it will be to achieve the desired effect. Without wishing to offer a counsel of despair, the ideal time to have started IHT planning is always seven years ago. The reason is that all outright gifts of any value made that long before the donor’s death are entirely free from tax. Under the ‘potentially exempt transfer’ rules, any outright gift made more than three years before the donor’s death may reduce tax liabilities by means of a taper. So, when it comes to being generous, it’s better to start late than never.
Similarly, nothing could be simpler than making regular use of annual exemptions from IHT. Everyone is allowed to give away up to £3,000 a year to anyone — or a trust — of their choice. It is important to understand that this exemption is a case of ‘use it or lose it’. Any unused exemption from the previous tax year can be carried forward to the current tax year but no further. So, for example, a husband and wife could give away assets worth £12,000 in the current tax year if they both have the previous years’ exemptions available. If they remember to use their annual exemptions over a 20-year period, they could give away up to £120,000 from their combined estates tax-free and avoid a potential IHT bill of £48,000.
Where you wish to help several relatives or friends with regular donations of modest amounts, the small gifts allowance enables up to £250 to be given to any number of beneficiaries each year free of IHT. For example, a pair of grandparents could give each of their eight grandchildren £250 annually over 20 years, distributing a total of £80,000 and avoiding a potential IHT bill of £32,000.
Weddings offer opportunities to be generous in a tax-efficient way because each parent can give £5,000 to their child when they get married. Similarly, grandparents and other relatives can each give £2,500, while any other person can give £1,000 IHT-free on marriage.
Another simple strategy most families could consider to reduce their tax liabilities is ‘equalisation’. Married couples and those in registered civil partnerships can make IHT-free transfers to each other during their lifetime or on death. By equalising their estates, they can avoid up to £114,000 of IHT by making sure that both partners make full use of the £285,000 nil-rate band. By contrast, many couples merely leave everything to the surviving spouse, which means that when the first partner dies, no use is made of the nil-rate band and up to £114,000 of unnecessary tax is paid when the second partner dies.
At the more rarified end of tax planning, wealthy individuals can make substantial savings, without any fixed maximum value, by making use of the exemption for regular gifts out of income. The donor must be able to show that the gifts are habitual, although that does not necessarily mean every year. These gifts must be made from post-tax income and leave the donor with sufficient income to maintain their usual standard of living.
Similarly, large amounts of IHT can be avoided by estates substantial enough to invest in agricultural land, business assets or some shares traded on the Alternative Investment Market (Aim). The last exemption has helped to more than double investment in Aim stocks over the last year to about £5 billion, but the rules as to which shares qualify for IHT exemption are subject to differing interpretations. There is also a risk that these investments could fall in value by more than the potential tax savings which prompted them. As a general rule, don’t let the tax tail wag the investment dog.
All of these more rarified exemptions can be regarded as examples of the Revenue giving tax-planning advantages to the rich which are effectively denied to people of more modest means. As a result, some or all of them could be vulnerable to attack by Gordon Brown — assuming that he has at least one more budget left in him — or by his successors.
The important point to remember is that IHT liabilities are calculated in relation to the estate and the laws in force at the time of death — not at the time when the will was drawn up or any other arrangements were made. As the imposition of POAT and this year’s tax on trusts demonstrate, it is vital to review IHT planning regularly with a professional adviser to ensure that your family’s strategy has not been overtaken by events. You can’t take it with you, but that’s no reason to give the taxman any more than you have to.
Ian Cowie is personal finance editor of the Daily Telegraph.