How to pass wealth on to the next generation
Most of us aspire to pass wealth on to the next generation, but unless you manage the process carefully you can end up needlessly losing hundreds of thousands of pounds to taxation. Though it pays to take professional advice, here we suggest some general issues to consider.
Article by, Emma Watson, Head of Financial Planning, Rathbones
James and Rosie Bamford never imagined Inheritance Tax (IHT) would be a problem for them, but when they read details of the recent Budget they realised this is something they now need to address.
James is an optician. Rosie is a head teacher. They are both in their mid-50s and plan to retire at 60. They have two young adult sons, Archie and Tom.
The Bamfords live in a detached house worth about £1 million. They have £800,000 in their Rathbones account and £50,000 in cash and savings. James has a pension pot of £1 million. He expects to inherit £600,000 from his mother’s estate at some point.
That means IHT is definitely an issue they need to think about. Not all that money will be liable for IHT. Let’s look at the core allowances.
Savings in a money purchase pension usually do not count in your estate for tax purposes and are therefore currently exempt from IHT. So are any donations you make on death to a charity or community amateur sports club.
We each have an IHT tax-free allowance, known as the nil-rate band, of £325,000. If you leave your home to your children (including adopted, foster or stepchildren) or grandchildren your threshold can increase by £175,000. This extra allowance is known as the main residence nil-rate band.
These are individual allowances. If you are married or in a civil partnership and your estate is worth less than your threshold, any unused threshold can be added to your partner’s threshold when you die. This means the surviving partner’s threshold can be as much as £1 million.
However, for every £2 your estate is valued at over £2 million you lose £1 of your main residence nil-rate band. That IHT taper means couples with an estate valued at between £2 million and £2.7 million — and the Bamfords could easily find themselves in this area — will see their residence nil-rate band gradually eroded to nothing.
The impact of that taper is significant. If both the Bamfords were to die tomorrow, their estate would be worth £1,850,000. Their IHT bill would be £340,000 and the taper would not apply.
What is more likely to happen is that James’s mother will die first and they will inherit £600,000. This inheritance will take them over the £2 million threshold, meaning that — assuming the other numbers remain the same — the IHT bill on their death would nearly double to £670,000. In reality they are being taxed 55% on that inheritance.
Coronavirus and the fiscal drag on finances
HMRC receives over £5 billion a year from IHT, and this figure is likely to increase. The Chancellor has a budget deficit of £280 billion this year. In the March Budget he froze many allowances as he began looking for ways to repair public finances.
As a result, it is inevitable that more families, like the Bamfords, will find themselves caught by IHT. Inflation alone will be sufficient to tip many households into the IHT trap.
Around the world central banks have printed money to help combat the impact of the coronavirus on the economy. Many economists are concerned that this will ultimately lead to serious inflation. The current inflation target for the UK is 2%.
Let’s imagine the government manages to contain inflation to 2% here but it still leaves those IHT allowances frozen at their current level. In 10 years the Bamfords' £1 million house would be valued at over £1.2 million. Investments that are well managed and growing and surplus income all add to the issue.
I mentioned earlier that pensions are exempt from IHT, but these were also caught in the allowances freeze. The standard Lifetime Allowance — the amount you can accumulate in pension savings over your lifetime without incurring tax charges — was frozen at £1,073,100.
If James’s £1 million pension grows by 5% a year it will be worth £1,276,000 when he retires in five years’ time, taking him beyond the limit. He will pay 25% on any money he withdraws as income from his pension that is over the Lifetime Allowance — on top of income tax — or 55% on any lump sum.
However, he can currently leave his pension to loved ones. This is a great way of helping children and grandchildren with their own pension savings plans. And it may be worth considering giving some other surplus money away now.
Giving money away
- Under Potentially Exempt Transfer (PET) rules, you can pass on property, assets and possessions free of IHT as long as you do not die within seven years.
- You can give away £3,000 worth of gifts each tax year (so £6,000 for couples) without triggering the PET clock.
- Each year you can also give away wedding or civil ceremony gifts of up to £1,000 per person (£2,500 for a grandchild or great-grandchild, £5,000 for a child).
- You can give payments to help with another person’s living costs, such as an elderly relative or a child under 18. You can also support a child’s higher education cost.
- You can give away the family home, but to carry on living in it you will need to pay the new owner the market-rate rent and continue paying the bills. We certainly would not recommend this without advice.
Gifts out of normal expenditure
One of the best ways to give is out of your income. This is particularly attractive, for example, for those with high final salary pensions that they cannot avoid receiving and that exceed their expenditure. You have to show that you can maintain your standard of living after making the gift. You should keep good records. It may be prudent to set up regular payments. You can give as much as you can afford through this mechanism. And, again, it does not trigger the PET clock.
One attraction of this is that it allows you to give gradually over time. Few of us know how long we have got or how much we will require. This mitigates the need to make a big decision on gifting too early.
One final thing to consider is that if you leave 10% of your net estate — the element liable for IHT — to charity your IHT rate will fall from 40% to 36%. As a result of this, if you are planning to leave between 4% and 10% to charity anyway, your beneficiaries will be better off if you lift your gifts to the 10% mark.
Establishing a personal charity and making larger gifts to benefit a specific cause may also be a consideration for larger estates.
I must stress again that IHT planning is complicated and that it is worth taking professional advice if you are concerned about this issue.
A good adviser can help you devise a sound gifting plan. They can help you make best use of tax-efficient savings tools, like ISAs and pensions, as you are accruing wealth. And they can advise on taking money from the right pots in the right order in retirement.
At Rathbones we can help manage any significant gifts you make to children and grandchildren, to ensure the money is invested appropriately and wisely until they need it.
You may not be able to avoid paying IHT, but with careful planning you can reduce the bill so that loved ones receive more of your wealth.
Rathbone Financial Planning is part of Rathbone Investment Management Limited.