How to inherit wealth tax efficiently
If you are from one of the pre-baby boomer generations, X, Y or Z, you are likely to be one of the lucky people to share the inheritance of an estimated £5.5 trillion from the older generations between now and 2047. Yes, you read it right – £5.5 trillion! That’s an awful lot of noughts. Eleven to be precise.
In my financial planning business, Wealth And Tax Management, I regularly advise my baby boomer generation clients to openly discuss their wealth with their children and to share with them their wishes. We think it is very important to include all close relatives in these discussions. After all, most older clients appoint their children to be their executors, attorneys and trustees in any case. Their children have already been entrusted to look after their parents’ wealth when they become mentally and/or physically impaired and of course after they have passed away. However, research shows that not many of these parents have openly discussed their wealth with those very same children who often only have a vague idea how wealthy their parents are.
We find that once their finances have been openly discussed and their heirs know how much they are likely to inherit they are then able to work together collaboratively to achieve their desired outcomes. This also ensures there are no problems after the parents pass away. This is vitally important because it avoids costly disputes over Wills post-death which is in nobody’s best interests.
Because we are all living longer parents and grandparents are increasingly passing on some of their wealth to their children and grandchildren while they are alive. This is because it is better to assist your descendants financially when they are younger rather than wait until they themselves are retired.
Another reason for open discussions is because it is important to ensure that wealth is passed down the generations tax efficiently. Getting tax planning right can save significant amounts of tax.
Let me give you a few examples.
Defined contribution pensions such as personal pensions and company money purchase pensions e.g. workplace pensions may now be inherited by children after their parents’ deaths. The default position is for these pension death benefits to be paid to beneficiaries as cash lump sums. The problem with this is that the cash then forms part of the beneficiary’s estate for Inheritance Tax, IHT, purposes whereas if the pension fund itself were inherited instead it would remain outside the beneficiary’s estate and be IHT free. What’s more, it would be protected against claims from a future ex-spouse on divorce or from creditors generally if written into trust. The beneficiary could even draw money out of the pension after age 55 completely tax-free if the deceased parent died before age 75. If the parent died after age 75 withdrawals from the pension fund would be subject to Income Tax only. So it is important to ensure that your parents’ money purchase pensions have the facility to allow beneficiaries to inherit them. Many such pensions do not have this facility so it may be worth considering transferring such pensions to pensions that offer this option whilst parents are alive.
A further benefit of inheriting a pension fund is that it does not get added to the value of the beneficiary’s other pensions in calculating the Lifetime Allowance which is currently £1,073,100. Bearing in mind the penal tax rates when pensions exceed this amount and the tax charges apply this is an absolute gift by the taxman (as well as the donor).
Parents and grandparents and, in fact, anyone can pay money into anyone’s money purchase pension scheme even minor children’s or grandchildren’s Junior Pensions. This is known as third party contributions. The advantage of this approach is that the contributions are classed as gifts by the donors for IHT purposes therefore their estates are reduced for Inheritance Tax. Furthermore, the contributions are deemed to have been made by the donees for Income Tax purposes. This is highly tax-efficient especially where the donees are higher rate taxpayers as they are able to claim 40% tax relief on pension contributions into their scheme made by someone else! You really couldn’t make up this sort of stuff, could you?
Virtually all of our baby boomer clients have ISAs. ISAs lose their Income Tax and Capital Gains Tax free status on death and become subject to IHT. When a spouse or civil partner dies the surviving widow/widower can make an extra ISA allowance claim up to the value of the inherited ISAs. This is known as the Additional Permitted Subscription (APS) allowance. So widowed parents should be encouraged to apply for this allowance. The time limit to make the claim is within three years of the date of death.
Better still is for parents and grandparents to consider transferring at least some of their ISAs into AIM ISAs while they are alive. AIM ISAs consist of shares traded on the secondary stock market known as the Alternative Investment Market. Some but not all AIM stocks qualify for what’s known as Business Relief. This is an HMRC tax relief against Inheritance Tax when you have invested in a qualifying trading company for at least 2 years. Qualifying AIM stocks give the investor 100% business relief against IHT. AIM ISAs typically invest in the 30 largest AIM stocks as a portfolio so the risk is diversified. They are considered to be higher risk investments because they invest in smaller companies and there is no investor compensation available. Nonetheless, they represent a simple way to mitigate IHT after just 2 years of ownership and are worth considering at least.
Furthermore, like pensions it is possible for parents and grandparents to pay into ISAs for someone else such as children and grandchildren including minors, though the ISA allowance for Junior ISAs is £9,000 as opposed to £20,000 for adult ISAs. Again such third party contributions count as gifts for IHT purposes for the donors.
Pensions and ISAs are just two ways to pass wealth down the generations. There is a multitude of ways to pass wealth down the generations. These are just two of them.
So my message to you is: have that open discussion with your parents, make sure you and they have up to date Wills and both types of Lasting Power of Attorney. Then consult with your professional adviser/s on how to pass wealth down the generations tax efficiently both during their lifetimes and post-death. You know it makes sense*.
*The contents of this blog are for information purposes only and do not constitute
individual advice. All information contained in this article is based on our current
understanding of taxation, legislation and regulations in the current tax year. Any
levels and bases of and reliefs from taxation are subject to change. Tax treatment is
based on individual circumstances and may be subject to change in the future.
Although endeavours have been made to provide accurate and timely information,
we cannot guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future.