This article is taken from Merryn Somerset Webb’s free weekly personal finance email, Money Sense. Click here to sign up now: Money Sense
There has been much talk about how Alistair Darling has doubled the inheritance tax allowance. This is all very irritating for the very simple reason that he has done nothing of the sort.
Before his pre budget speech on October 9th everyone was able to leave £300,000 to his or her heirs tax-free. Anything over and above that was taxed at 40%. It also used to be the case that, while their allowances died with each of them, couples could leave a total of £600,000 (£300,000 + £300,000) tax-free to their children.
For the rich this was easy. The first person to die simply left £300,000 to some one other than their spouse taking £300,000 out of the estate. Then when the second died she also left £300,000 tax-free and the rest at 40%.
For the not so rich it was a bit harder: if most of a couple’s assets are tied up in say a house that the survivor will want to live in it isn’t that easy to hand over £300,000 worth of it on the first death. Too often this meant that the first to die left everything to the other (remember that transfers between spouses are entirely tax free) wasting his own allowance to make sure she had enough to live on until her own death. On her death her heirs then benefited only from her allowance of £300,000.
The solution to this for the IHT aware has long been to use a variety of nil rate band trusts whereby the first £300,000 of an estate is put in trust for the heirs on the first death. This means that the cash or asset in question is still available to the survivor but, with the heirs as final beneficiaries of the trust, it is also outside the estate. These are relatively simply structured trusts and cost around £5000 to set up and £2000 a year to run.
So what’s changed? If you are not married, nothing. If you are married, the admin. From now on married couples and civil partners are to be able to combine their allowances without bothering with the reams of accountants, IFAs and lawyers who they once relied upon to set up their trusts. How? By transferring any unused part of their allowance to their partner.
This is brilliant news for those who have done no IHT planning whatsoever and have estates worth less than £600,000 (now they don’t have to feel guilty about it – their indolence has been well rewarded) and particularly good news for the children of widows and widowers whose dead partners never used up their own nil rate bands – the new rules work retrospectively so when their second parent goes they’ll still get up to £600,000 tax free. No trusts needed.
But what of those with estates worth more than £600,000? They may have higher allowances but they’re still going to get stuck with a bill of some sort. How can they keep the tax bills of their heirs down?
There are still lots of clever wheezes about for this – the same nil rate trusts will keep on working for large estates and there are still several investments that can be passed on IHT free (farmland, forest land, Aim stocks and so on). You can also make as many gifts out of income as you like as long as they don’t affect your own lifestyle – if you have a high income and a modest lifestyle you should be able to get rid of quite a lot of cash in this way.
However just because something is fiendishly clever doesn’t mean it will work. I keep getting asked if offset mortgages can be used to cut IHT bills and at first glance this seems like a piece of pure IHT brilliance. Here is one of the reader letters that explains the concept:
“Dear Merryn,
I wonder if the following a potential way of avoiding Inheritance Tax:
We (parents) take out a new interest only Offset mortgage, sufficient to bring the remaining equity in our home well below IHT threshold to allow for future house price inflation.
We give the kids the money. They put it into their own savings accounts which are linked to the offset mortgage.
The kid’s offset savings accounts reduce our mortgage payments to (nil?).Providing we survive 7 years, and the kids haven’t run off with the money, are we then legally avoiding IHT?”
It sounds great doesn’t it? I was so taken with the idea that I called IFA Craig Davidson and asked him to find the flaws, which I’m sorry to say he did. Here’s his main point:
“IHT works on the basis of “loss to the estate”. If one is to make a gift and start the 7-year clock ticking, the gift has to truly leave the estate. If there is the option for the gift to return into the estate, or indeed benefit still to be enjoyed by the estate of the gift, then the revenue deem the gift to have never been made. In this case, the funds raised would be gifted to the kids, put in a bank account which then reduces the parent’s mortgage payments. The parents are therefore still benefiting from the funds and so the 7- year clock has not started.
One final thing – The revenue often fall back on the anti-avoidance doctrine. This basically says if you go from A to B and get taxed, and so to avoid this you go from A to C to D to B, which would normally not be taxed, they will ignore the extra steps and deem you to have gone directly from A to B – and tax you accordingly. There must be a reason for taking the extra steps, other than simply to avoid tax.”
It’s a shame but I’m afraid that seems to knock what looked like a fantastic idea on the head. Any other ideas gratefully received.