Inheritance Tax Planning - A Framework

I don’t know if you’ve heard, but pensions are to be caught within the Inheritance Tax “net” from April of next year. And for folks with large pensions, that will mean a large increase on the liability that their estates will have to pay.

Now, at this point, I have no idea what your opinion on Inheritance Tax is. You might be quite happy to pass on a decent wedge of your hard earned to the state when you shuffle off, you may not be.

This recent survey would suggest you are more likely not to be too thrilled by the prospect, but surveys are bunkum at the best of times and especially in this lovely little post-truth era of ours - so who knows.

But I am going to assume that if your estate already has, or will have, an Inheritance tax liability - that you would like to do something about it.

Which brings me neatly onto this framework for Inheritance Tax planning which I’ve been kicking around in my head over the past couple days. It’s pretty nascent, and I haven’t had a chance to take it out into the wild yet - so bear with me and maybe take with a pinch of salt.

Source: The Money Den and my boy Claude.

There are a couple of initial advantages to this approach I think. One, it is relatively simple.

And two, it takes advantage of the tendency we all have to “mentally account” with our money - seeing different pounds as having different jobs. We all have our in-built biases hardwired into us, why not try to use them for good?

Anyway, to the pots!

Pot 1: “Live your best life”

Regardless of what age you are, you will need some money to continue to live on. Luckily the whole point of having a financial plan is that you have an idea of how much you’ll need.

Pro tip - allocate a bigger slug of money to this sleeve than you might think is necessary. Three reasons why:

1. The most Inheritance Tax efficient thing you can do is spend more money - go out in a blaze of glory. Go on that holiday, fly first class, go for the nice meal. Don’t be a martyr - there is no glory in modesty. But bigger spend needs a bigger pot 1 to support it.

   
   

2. We are all living longer and chances are a lot of us will need care in future. At the moment the cost of care is rising much faster than the prevailing rate of inflation as demand outstrips supply, so probably best to assume that this continues.

   
   

3. It is natural to be terrified of running out of money after working so hard to build up a sizeable nest egg. If it takes having a few more quid in pot 1 than is strictly necessary to save on some stress, then that is money very well spent.

   
   

Once this pot is present and accounted for, we can move onto the tax planning.

Pot 2 - The Income Pot

This is where it all gets a little more technical so stick with me.

When we talk about “income” in this case I refer to interest, investment income and pension income.

If our regular income (after tax) is higher than our normal living expenses, then we can begin to make regular gifts which immediately fall outside of our estate for the purposes of calculating Inheritance Tax.

Where the rubber meets the road in the new world, is if client has a large pension pot that falls inside of their estate but which they do not necessarily “need” to access all of. Regular withdrawals from a Defined Contribution pension count as “income” for the purposes of this exercise - and therefore any surplus taken from a pension can be gifted onto children, put into trust or gifted directly into someone else’s pension.

This is a really attractive exemption - and for that reason we cannot discount the possibility that the current or a future government will close it. But them’s the rules for now and we can only plan based on what we know today.

At the very least I would expect HMRC to become more stringent in the enforcement of this exemption - particularly for larger estates. If this is a route I am going down with clients, we will be going through an exercise of regularly pre-filling out page 8 of the IHT 403 form which is used to claim gifting exemptions on death.

If enforcement will be primarily done administratively, we must be prepared.

Source: HMRC

Although dividends and interest from our investments and savings count as “income” here - the original capital and growth do not. Bonds are technically non income generating assets by their very nature, and so are incapable of yielding an income for the purposes of this exercise.

Which brings us neatly onto pot 3.

Pot 3 - The Legacy Pot

We are left with everything which we don’t need ourselves, and which cannot be used as an income.

With this money, we have several options available to us. Which one is the right one depends very much on your age, personal views and family situation.

1. Give it away - simple, clean, yes. After seven years the gift is outside of your estate and there is (currently) no lifetime limit to the amount of money that can be given away like this. You also get to see the fruits of your generosity, which is nice.

   
   

   But you have to get comfortable with the idea of losing control of this money and if you are giving it to a married family member, be aware that this cash would very likely be split in a divorce.

   
   

2. Make a gift into trust - allows you to get the clock rolling on a gift (gifts into trust are subject to the same seven year clock as outright gifts), and retain a level of control over the money (as presumably you would wish to appoint yourself as a trustee).

   
   

   However, trusts can be subject to chunky tax liabilities depending on how much is gifted into them and there is the additional hassle of setting up and administering the thing.

   
   

3. Invest into Business Relief qualifying investments - Probably worth a blog post on its own at some stage these. Investments into Business Relief qualifying companies are exempt from Inheritance Tax after two years, rather than seven, so these products have historically been used by older clients.

   
   

   However, they are now becoming more popular across the board, which presents its own risks, because the private companies and assets these schemes invest into are often not readily liquid (easily sold). So there is the danger that if inflows into these funds stop, your beneficiaries may struggle to get the money out of the scheme quickly when the time comes.

   
   

   Overall an attractive option but product selection is really important, you need to be aware of the risk and size the investment accordingly.

   
   

4. Go for growth - Criminally underrated option. The Darren Fletcher of the Inheritance Tax planning world.

   
   

   60% of £2 million is a bigger number than 100% of £1 million last time I checked, so why not just “get the foot down” and try to grow pot 3 as much as possible to leave your beneficiaries with as large a net estate as possible? Your kids get a good whack of cash, and so do the state.

   
   

   If it’s big enough, they’ll maybe build a statue of you or name a library wing after you (they won’t).

None of the above is intended to represent advice to any individual. If you have specific queries regarding your situation please consult with a regulated financial adviser.