Thanks to the legislation first announced by the Government in July 2015, married couples and civil partnerships could have an Inheritance Tax allowance of up to £1,000,000 on second death by April 2020 (£500,000 for individuals). This £1,000,000 tax free band is made up of £650,000 Nil Rate Band (£325,000 for individuals) and £350,000 of the newly introduced Residence Nil Rate Band (£175,000 for individuals). These allowances are due to increase in line with inflation each year from 2021 onwards. For those that have a taxable estate in excess of these allowances, this will still be subject to an eye-watering tax rate of 40%.
The introduction of this additional tax-free band is obviously good news for those wanting to be able to pass on their wealth. But it is important to note there are several pitfalls to Inheritance. In this article we discuss 6 potential pitfalls that you should be wary of when planning ahead for you and your future generations:
1 – Tapering Of The Residence Nil Rate Band
The amount of price growth witnessed in the UK housing market over the years pushed many homeowners, with what could be a called a relatively modest estate, into Inheritance Tax territory. The introduction of this new band by the Government was a way of reducing the number of people with this issue. However, the caveat to this new tax-free allowance was a taper introduced by the Government, which states as follows:
“The additional threshold will gradually reduce, or taper away for an estate worth more than £2 million, even if a home is left to direct descendants. The additional threshold will reduce by £1 for every £2 that the estate is worth more than the £2 million taper threshold.”
What that means in practice is, for example, if a married couple has a house worth £1 million and other assets worth £1.6 million (£2.6 million total) all held in joint name, their Residence Nil Rate Band from 2020 would not be £350,000, as it would be tapered. This is because their estate would be £600,000 in excess of the £2 million threshold and therefore their Residence Nil Rate Band would be reduced by £300,000 (£600,000 / 2). This means their combined Residence Nil Rate Band would be £50,000 only. This loss of Residence Nil Rate Band would cost their beneficiaries an additional £120,000 in tax (£300,000 @ 40%).
The one bit of good news is that this taper will also increase in line with inflation from 2021. However, it is plausible that people’s assets will grow in line with inflation as well (or possibly more). So, for those with an estate close to or above the £2 million threshold, it is worth reviewing your position to see what can be done to make your estate more tax efficient from an Inheritance Tax perspective.
There are a couple of tricks available to individuals and couples to win back their Residence Nil Rate Band. If you want to talk to us about how to easily win back your Residence Nil Rate Band, click here.
2 – House Value Lower Than The Residence Nil Rate Band
Having an estate worth less than £2 million doesn’t guarantee a couple the full Nil Rate Bands either. There is yet another caveat with the Residence Nil Rate Band:
“The amount of the additional threshold (RNRB) due for an estate will be the lower of:
- the value of the home, or share that direct descendants inherit
- the maximum additional threshold available for the estate when the person died”
This may not seem like much of an issue, but consider the following example:
A couple have the following assets
- Main Residence: £250,000
- Investment Portfolio: £650,000
- Cash: £100,000
- Total: £1,000,000
They might believe that because their estate is all within the £1,000,000 threshold that therefore their beneficiaries won’t have to pay any tax. However, because their house is only worth £250,000, which is £100,000 less than the Residence Nil Rate Band, they will only be entitled to a threshold up to the value of their house. This couple’s total Nil Rate Band is as follows:
- Nil Rate Band: £650,000
- Residence Nil Rate Band: £250,000
- Total: £900,000
This means this couple have £100,000 of assets in excess of their allowances, which would result in a tax bill of £40,000.
The Government did introduce a rule that allowed those who wish to downsize to retain the benefit of the RNRB. However, the following conditions must apply:
- the person sold, gave away or downsized to a less valuable home, on or after 8 July 2015
- the former home would have qualified for the additional threshold if they’d kept it until they died
- their direct descendants inherit at least some of the estate
3 – Dying Within 7 Years Of Making A Gift
It is not uncommon for people to gift money to their children or beneficiaries throughout their lifetime. When making a gift, there are some exemptions afforded by the Government, which include the following:
- An Annual Gift Allowance of £3,000
- Gifts worth less than £250 to as many people as you want (although not to somebody if they have already received a gift of your £3,000 annual exemption)
- Gifts to help with living costs for an ex-spouse, elderly dependant or child under 18
- Regular gifts from surplus income
- Wedding gifts (£5,000 for a child, £2,500 for a grandchild, £1,000 for anyone else)
If a gift is made in excess of these allowances, this gift is classed as a Potentially Exempt Transfer (PET). You do not immediately incur a tax charge when you make a PET and if you live more than 7 years after making this gift, the gift should fall outside of your estate and therefore not be subjected to inheritance tax.
However, if you make a PET and do not survive the gift by 7 years, the exemption fails, and the gift is counted in your estate and potentially subject to inheritance tax. Dependant on the size of the gift and how many years you survived the gift by, the gift could be subject to tapering – this means there would still be tax payable on the gift, but the amount of tax payable is at a reduced rate.
4 – Gift Into Discretionary Trust Above Your Nil Rate Band
Discretionary Trusts can be a valuable planning tool to give greater control over how your assets are distributed and ensure protection for future generations. In the previous point, we explained about making gifts, which are classed as a Potentially Exempt Transfer (PET). These sorts of gifts do not attract an immediate tax charge, but as mentioned previously do not guarantee they are passed on tax free. However, some gifts, for example, those that are invested into a Discretionary Trust, are classed as a Chargeable Lifetime Transfer (CLT).
Chargeable Lifetime Transfers are treated differently to Potentially Exempt Transfers and therefore due care must be taken with regards to trust and estate planning.
One of the key differences is the fact that making a Chargeable Lifetime Transfer can create an immediate Inheritance Tax charge as well as future tax charges.
To calculate if a tax charge is liable, the value of the CLT is added to any other CLTs made in the past seven years (and then this CLT must reference back another seven years to check for further CLTs). If the total of all these CLTs exceed your Nil Rate Band(s), then there will be an immediate tax charge of 20% of the amount in excess of your Nil Rate Bands payable. Trust planning is a very complex area and we would strongly recommend you seek advice before taking any action.
5 – Nil Rate Band Trusts
Married couples and civil partners can leave unlimited amounts to each other on death. This will not use their Nil Rate Bands and any unused Nil Rate Band on first death can be passed to the surviving spouse to use on the second death. This can double the £325,000 Nil Rate Band to £650,000 on second death. However, this was not always the case, prior to 2007 the Nil Rate Band could not be transferred. As such, to avoid losing the Nil Rate Band on first death, it used to be common practice that an amount equal to the Nil Rate Band would be left in each of a couple’s will to a trust of which the survivor would typically be a beneficiary.
These trusts can create a further obstacle to obtaining the Residence Nil Rate Band as one of the criteria for the Residence Nil Rate Band is that the house is left to direct descendants. Where the house value is transferred into a discretionary trust on death this would not be considered as being passed to a direct descendant, even where direct descendants may be the eventual beneficiaries.
We are speaking with a lot of clients who still have these provisions in their will and encouraging them to review this position. These arrangements may still be beneficial in particular for larger estates where certain assets (other than the main residence) can be passed into the Nil Rate Band trust. Many people will like the idea of being able to pass a legacy to their children on first death that the survivor can see the children enjoy.
6 – A £2 million Nil Rate Band, Surely Not?
Unbelievably, it is possible. As explained above, on first death that the surviving spouse can inherit the unused Nil Rate Band and Residence Nil Rate Band of the first to die, potentially giving them £1 million in allowances. Were two individuals who have both been widowed to remarry each other, they potentially have a combined £2 million in IHT allowances. However, the important thing to note is that a person can only ever have a maximum on two allowances (i.e. a total of £1 million at present). What this means is, in the above example, if the first to die left everything to the surviving spouse the allowances they inherited from their first marriage would be lost. The second to die would be limited to allowances of up to £1 million. This can be circumvented by careful planning. In order to maximise the allowances on first death each spouse would need to leave the value of their estate, up to their available allowances to someone other than their spouse (for example children or other direct descendants). The excess can be left to the surviving spouse free of Inheritance Tax who will then have their own £1 million in allowances available to use on their death.
This is an extreme example, but the principal, and the need for planning, still applies where there is a marriage and one of the two individuals was previously widowed.
This a niche area of planning and personal circumstances will dictate whether it is possible to maximise the allowances. Second marriages can be very complicated and in many cases achieving the maximum possible tax efficiency will not necessarily result in assets being distributed in accordance with everyone’s wishes. Children from earlier marriages and where one partner has brought a significant amount more to the marriage than the other can often complicate matters. Again, this is another area that is extremely complicated and that should be discussed with a suitably qualified professional if you think this may be applicable to you.
Use our calculator to view your current Inheritance Tax liability
or to speak to one of our IHT Specialists call