The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.

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Delivering the right outcome

A case study in IHT planning
Jamie Kinnear, Financial Planner21 Jul 2021

Benjamin Franklin once said, “In this world nothing can be certain, except death and taxes”.

Nobody likes paying taxes, even less so taxes on death where your children or grandchildren could be subject to 40% tax on their inheritance. There are several potential tax-efficient solutions which aim to mitigate your inheritance tax (IHT) liability on death. The suitability of these solutions will depend on your own personal circumstances and objectives which is why it is so important to get financial advice.

We’ve outlined a real-life case study on how we helped solve a combination of complex IHT issues for a client after her husband passed away at age 55.

Case study – Mrs Hagen

Mrs Hagen is a 56-year-old widow who retired two years ago after her husband passed away after a battle with Motor Neurone disease. She is in good health and has three children aged 18, 20 and 23 who are all at University. She has a valid Will and the family estate will be passed to her children equally on death. She would like to ensure that her estate remains within the family but would like her children to establish themselves before making any sizable financial gifts.

Her estate is worth £5.5m and consists of properties worth £1.3m with the remainder held in cash deposits, ISAs, pensions and an investment portfolio. She has no debt or other liabilities. She has guaranteed pension income of £50,000 p.a. and requires £100,000 p.a. to cover her core and discretionary spending.

She inherited 100% of her deceased husband’s Nil Rate Band (currently £325,000 in 2021/22), which when added to her own Nil Rate Band gives her a total of £650,000. She set up a trust for her children 10 years ago when her husband was first diagnosed and received his death in service payment of 4x salary and occupation pension lump sum of £1.7m as cash. Under current legislation, her own pension assets valued at £350,000 are not subject to IHT on death.

Clients objectives

  1. To live a comfortable retirement with an income of £100,000 p.a.
  2. To leave as much of her estate to her children as possible.
  3. To have her investments and pensions professionally managed so she can spend more time enjoying retirement.
  4. To have control over her children’s investments, with the ability to access capital and income to support children financially when required.

Current position

If Mrs Hagen had not taken any financial planning advice, her children could be liable to pay a 40% tax on the value of her estate over £650,000 as shown below:

Total estate: £3,500,000
less
Nil Rate Bands: £650,000
= Taxable estate: £2,850,000

40% on £2,850,000 would amount to £1,140,000 in tax, making HMRC potentially the largest beneficiary of Mrs Hagen’s estate.

We go on to later explain how we removed £1.7m from taxable estate immediately in the “What I did to solve Mrs Hagen’s IHT problem” section further below

How RNRB reduces for estates worth more than £2 million

The Residence Nil Rate Band (RNRB) was introduced in April 2017. The allowance is currently £175,000 per person and is in addition to the Nil Rate Band of £325,000. The allowance is conditional on the main residence being passed down to direct descendants (e.g. children, grandchildren).

The RNRB will gradually reduce, or taper away, for an estate worth more than £2m, even if a family home is left to direct descendants. In this case Mrs Hagen’s RNRB was tapered away leaving no remaining Nil Rate Band, however this can potentially be reintroduced again in future if total taxable assets fall below £2m.

Looking after you before looking out for them…

Before planning for what your heirs may inherit on death, we always recommend that your own needs are looked after and recommend that the following fundamentals are considered before implanting any mitigating IHT solutions:

  • Income – Covering fixed and discretionary spending needs and planning cash flow.
  • Capital – Having an accessible contingency fund held in cash for emergencies.
  • Access – Ensuring some investments or pensions are accessible if needed later.
  • Risk – Testing your capacity and tolerance to risk.

Delivering a bespoke outcome

When looking at the suitable solutions and to ensure we are delivering a truly bespoke outcome, it’s important that we understand and take into consideration your own personal circumstances, objectives and requirements. This could include:

  • Using available exemptions and reliefs.
  • Changing your investment strategy.
  • An appropriate Trust arrangement.
  • Appropriate life assurance policy written under Trust.
  • An investment into a scheme which will qualify for tax reliefs, including business property relief.
  • Gifts that will qualify as Potentially Exempt Transfers or Chargeable Lifetime Transfers.

What I did to solve Mrs Hagen’s IHT problem…

Through detailed holistic planning we were able to meet Mrs Hagen’s income needs whilst mitigating her full IHT liability through a combination of various holistic planning solutions that would remove the full liability to IHT over a period of seven years as summarised below.

Upon further investigation and working alongside Mrs Hagen’s Solicitor and Tax Adviser we established that we were able to be pay the death in service and pension lump sums into the existing trust for the benefit of her three children. This meant that we could remove £1.7m from her taxable estate immediately.

We invested this £1.7m into an offshore investment bond discretionary managed and wrapped in the existing discretionary trust for the benefit of her 3 children. Capital withdrawals of 5% of £1.7m (£85,000 annually) were taken to help her children financially for things such as house deposits, funding ISAs and pensions.

After removing the £1.7m of assets from her estate Mrs Hagen’s IHT liability would now be £1,140,000 in the event of her death. We recommended a range of bespoke solutions to help mitigate the full IHT liability.

Firstly, we invested £1.1m into an offshore investment bond discounted gift trust discretionary managed and wrapped in an absolute trust for the benefit of 3 children.

Capital withdrawals of 5% of £1.1m (£55,000 annually) were recommended to top up her pension income. An immediate discount based on her age, health and life expectancy of £641,000 was applied to the initial investment amount meaning that £641,000 was removed from Mrs Hagen’s taxable estate immediately and the remaining £459,000 would fall outside of client’s taxable estate after seven years. Capital withdrawals are tax deferred for 20 years and not subject to income tax meaning Mrs Hagen receives a tax efficient income for her retirement.

Secondly, we invested £400,000 into a business property relief (BPR) discretionary managed investment portfolio. Investments that qualify for BPR can be passed on free from IHT upon the death of the investor, provided the shares have been owned for at least two years at that time. These types of investments are higher risk in nature therefore it is imperative to ensure they are suited to the investors circumstances and objectives. This investment could be outside of her taxable estate after two years and still be accessible to Mrs Hagen should she need access to these funds in the future.

Next, we implemented a Royal London Whole of Life IHT assurance policy with a sum assured of £540,000 that would pay out a tax-free lump sum on death to pay the remaining IHT liability. This policy was set up in trust for Mrs Hagen’s three children to pay the remaining IHT within six months of her death. The policy is reviewable after five years and sum assured can be adjusted to meet client’s needs and the policy was paid from a combination of surplus income and income generated from her investment portfolio meaning the monthly cost had no detrimental impact or her lifestyle in retirement.

In addition to the solutions above we also invested £100,000 into a 7IM stocks and shares ISA invested in a discretionary managed income portfolio with £4,500 tax free income withdrawals made annually to help pay for the Whole of Life Assurance policy premiums.

Mrs Hagen’s £350,000 7IM SIPP was invested in a discretionary managed growth portfolio and the beneficiaries were changed to her three children so they can inherit this free of IHT on death. Pensions are not subject to IHT, so this is another tax efficient solution.

I also recommended that Mrs Hagen gifted any surplus income – this the most underused and overlooked form of IHT planning. For a gift to be exempt as a gift out of surplus income, the following conditions must be satisfied:

  • The gift must be part of your normal (i.e. typical or habitual) expenditure; and
  • The gift must be made from your after-tax income taking one year with another; and
  • After allowing for all other transfers of value forming part of your expenditure, you are left with sufficient income, in order to maintain your usual standard of living.

Delivering the right outcome for Mrs Hagen

Through detailed holistic planning I was able to meet all the client’s income needs whilst mitigating the client’s IHT liability.

  • Initial IHT Liability: £1,140,000
  • £1.7m from death in service payments and occupation pension lump sum moved outside of estate immediately – invested in an offshore investment bond
  • A further £641,000 outside estate immediately – £1.1m invested in a discounted gift trust (DGT)
  • £1,041,000 outside estate after 2 years - £400k invested in a BPR investment.
  • £1,500,000 outside estate after 7 years – remaining £459,000 invested in the DGT.
  • £540,000 Whole of Life IHT policy to be paid into trust on death to cover remaining IHT liability.

Total IHT saving: £1,140,000 or £380,000 per child.

If you would like to discuss your circumstances and address a potential IHT issue, please contact our financial planners who will be happy to explore this with you and advise accordingly.

The steps highlighted in this case study are intended as a general guide only. The information and/or any reference to specific instruments contained in this document does not constitute an investment recommendation or tax advice. Capital at risk. The value of your investments and the income from them may go down as well as up, and you could get back less than you invested. Tax rules are subject to change and taxation will vary depending on individual circumstances.

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