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Exposing the myths on IHT

IHT myth 1 - “My partner will inherit everything free of inheritance tax… won’t they?”

IHT myth 2 - “The residence nil rate band heralds a £1m IHT allowance for all.”

IHT myth 3 - “My property is my pension – and they’re taxed the same?” 

 

Myth 1 - My partner will inherit everything free of inheritance tax (IHT) … won’t they?

Many people assume that if they are married or in a civil partnership, UK IHT will not be an issue for them when their partner dies. However, this is not necessarily the case.   

Testamentary freedom is the ability to choose, where English law is available, who will inherit your estate on death, which normally requires a valid will to be in place.

What happens if you don’t have a will?

Without a will an individual dies ‘intestate’, which means a surviving spouse or civil partner benefits from £250,000 absolutely, and a life interest in half of the residual estate (assuming the couple have children). This is also particularly important for unmarried couples, as without a will, the surviving partner will not automatically inherit the full value of the deceased’s estate.

To complicate things further and quite surprisingly, a will remains valid upon divorce, but becomes void on marriage! Even then, just because a valid will is in place, which secures benefits to a spouse, it does not follow that the monies received are free of IHT.

Domicile can impact how you’re taxed

Whilst inter-spouse transfers are generally considered free of IHT, if the receiving spouse is a non-UK domicile, they are limited to the nil rate band of the deceased (currently £325,000), plus an additional, limited inter-spouse exemption of £325,000. This means that anything in excess of £650,000 will be subject to IHT at 40%. 

It’s also worth noting that if the recipient has a UK situs asset, or they become domicile at a later date, a further 40% IHT may be payable upon death, on the value already taxed.

Let’s look at an example:

Sally and Peter are married with children – Sally is a UK domicile and Peter is a non-UK domicile.  Sally’s will passes 100% of her £950,000 estate to her husband.  But when she dies suddenly and her estate is transferred to Peter, as a non-UK domicile, everything over £650,000 becomes subject to IHT. 

Peter moves on with his life and after a few years acquires a UK domicile.  However he doesn’t realise that when he dies some years later, and his estate is passed to his children, that the value of his estate over £325,000 will also be subject to IHT at 40%.

So the estate will effectively have been taxed twice.

Although, since 2013 a non-domicile spouse can elect to be treated as a UK domicile for IHT purposes, there are traps as well as opportunities in this course of action that require careful consideration.

Given the complexity of the domicile and the implications of IHT, people would be wise to carefully consider their financial position and be aware of the potential IHT tax implications and how they can be mitigated.

To read more on Old Mutual International’s offshore bonds, visit www.oldmutualinternational.com/products-and-solutions

and for more information on technical topics such as trusts and IHT visit our technical planning centre www.oldmutualinternational.com/technical-centre.

 

Myth 2 - The residence nil rate band now heralds a £1m IHT allowance for all

Prior to the 2010 election, David Cameron announced an ambition to raise the inheritance tax threshold to £1m per person. More than seven years later, strictly speaking the IHT threshold is still £325,000 per person and £650,000 for a married couple. 

Instead, on 6 April 2017, a significantly watered-down version of his promise was delivered in the form of the residence nil rate band (RNRB). This was made available for inherited residences (or financial wealth that represents properties once lived in), in addition to the existing nil rate band (NRB) which was then and currently remains at £325,000.  

How has the RNRB been phased in?

  • In 2017/2018 the RNRB started at £100,000
  • It has since been increasing by £25,000 each year and in 2019/2020 stands at £150,000
  • This will continue until 2020/21 when it will reach £175,000.  

As with the NRB, any unused RNRB can be transferred to a surviving spouse or civil partner, with the effect that the maximum combined IHT threshold for such couples will be a total of £1m by 6 April 2020 – this is shown here.

An individual has:

£325,000 IHT allowance + £175,000 (RNRB) allowance = £500,000.

Then a couple has:

£500,000 x 2 = £1m allowance.

But three qualifying conditions apply

Not only has the new exemption been designed to deliver a maximum of £500,000 per person, or £1m per couple (rather than £1m per person), but a number of qualifying conditions also need to be satisfied.

Its application is complex but, in basic terms, the RNRB may apply where:

  1. there is an interest in a property which has been used as a residence by an individual and/or
  2. it is left on an individual’s death to, or for the benefit of, direct descendants only.

If these conditions are met, a third test then applies:

  1. Is the estate over £2m?

This is important as the RNRB will be tapered away for estates over £2m. The taper is a £1 loss for every £2 in excess of £2m.

What does this mean for £2m+ estates?

As a result, estates over £2.2m during 2017/18 did not benefit from the RNRB at all.  But when the relief reaches £175,000 in 2020/21 (after being phased in as explained above), the cut-off will rise to estates over £2.35m.  

In light of this £2m taper threshold it’s important to keep the value of an estate under ongoing review. Remember that for this purpose, the value of the estate is calculated net of debts, but any reliefs or exemptions are not deducted.

One way to reduce the impact of tapering is to avoid 'bunching' of a couple's estate on the second death, as this will mean that the taper threshold is exceeded. In cases like this, it’s best to consider leaving property on trust for the survivor (instead of directly to them). 

Also, take care that a mortgage does not reduce the net value of a home below the amount of the available RNRB.

To read more on Old Mutual International’s offshore bonds, visit www.oldmutualinternational.com/products-and-solutions

and for more information on technical topics such as trusts and IHT visit our Technical Planning Centre www.oldmutualinternational.com/technical-centre.

 

Myth 3 - My property is my pension – and they’re taxed the same?

When it comes to saving money for retirement, many people state a preference for property over pensions. This is in spite of the fact that consecutive UK Governments have placed a greater tax burden on buy-to-let investors. Others are tempted to rely on their main home, either by downsizing or releasing equity.

Weighing up performance and risk
Property owners hope to enjoy capital growth and rental yields, compared to equities where capital growth and dividends are expected. Although equities are generally more volatile, the average UK house lost almost 25% of its value in 2008, whilst prime London (often thought of as an asset that only goes up in value), is down 20% in the last five years. 

Pensions, of course, are as volatile as the assets within. And a UK registered arrangement or QROPS, can hold an almost unlimited range of collectives and direct investments, although not residential property because of its ‘taxable property’ designation. So for those that like the idea of diversification, relying on a single asset class, (often with a single property), may be something to avoid.

Accessing cash
As of today, money purchase arrangements may allow flexi-access drawdown from the age of 55, while property is, in theory, saleable at any time. Though it is only as liquid as the ability to find a buyer, and often with significant trading costs, particularly if the 3% additional rate of stamp duty is payable for an additional property, as well as conveyancing and possibly management fees.

Easy to manage?
Property can be time-consuming and requires a lot of effort and expertise, including dealing with tenants and rent, agents, finance, tax returns, maintenance and insurance. Buying and selling is costly and slow, so that if you have more than one property, it can be like running a small business. Pensions, on the other hand, are easier to manage in terms of the day-to-day complexities, and the need to be hands on.

It all comes down to money in your pocket
Pre-retirement, a pension rolls up tax free, with the exception of irrecoverable withholding tax on dividends. A pensioner normally enjoys 25% pension commencement lump sum (PCLS) of their available life-time allowance, with the remainder drawn subject to income tax. Rental income is subject to income tax and capital gains, though not the principal private residence, at 18% or 28% if disposed during lifetime.

How about UK inheritance tax (IHT)?
Property counts towards an individual’s estate, which means it is subject to IHT if the nil rate band/residence nil rate band has been used. However, a pension can be enjoyed tax-free by beneficiaries if the pensioner dies before the age of 75. Once 75 or over, a pension isn’t usually subject to IHT, but beneficiaries pay income tax at their marginal rate.

As an alternative, investments held within an offshore bond can:

  • roll up virtually tax free
  • provide a tax-deferred withdrawal facility of up to 5%
  • be used in association with packaged IHT plans, such as loan trusts and discretionary gift trusts, although profits may be chargeable to income tax. This allows the client to benefit during their lifetime, often in their retirement, and simultaneously mitigate the amount of IHT they have to pay.

To read more on Old Mutual International’s offshore bonds, visit www.oldmutualinternational.com/products-and-solutions

and for more information on technical topics such as trusts and IHT visit our technical planning centre www.oldmutualinternational.com/technical-centre.

 

 

 

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth or Old Mutual International's interpretation of the relevant law and is correct at the date shown on the title page. While we believe this interpretation to be correct, we cannot guarantee it. We cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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