Clients often ask us about the most effective way of reducing their potential Inheritance Tax (IHT) bill.
If you’re in a relationship, own a property, and intend to pass your estate on to your children, Inheritance Tax is a big concern and something you should look at structuring correctly immediately. No-one wants to leave their loved ones with a tax bill reaching the hundreds of thousands, not when it’s possible to legally reduce the figure dramatically.
We’ve set out below how the Nil Rate Band works for married, common law & cohabiting couples.
The Truth About The Married Couples Nil Rate Band
In many cases, the single most effective way of reducing Inheritance Tax requires a religious ceremony or a registrar as opposed to an accountant or wealth manager.
There is no limit to the amount married couples can leave one another on the first death without being subject to Inheritance Tax (unless the first spouse died before 12 November 1974, in which case different rules will apply).
No amount of clever tax planning can match that, and as an added bonus the Nil Rate Band (the allowance that you can give someone free of IHT, currently £325,000 each) of the first to die can be passed to the survivor for use on their death.
Any inheritance left to anyone other than the surviving spouse on first death will reduce the amount that can be passed on to the survivor.
How The Married Couples Nil Rate Band Rules Work
As an example:
John and Mary – married
Mary is married to John, and she has £800,000 worth of savings. Mary predeceases John, leaving £700,000 of her savings to him and £100,000 to their son. In this situation, there is no Inheritance Tax to pay on Mary’s death, as the savings left to John are exempt from IHT and the cash left to their son falls within Mary’s Nil Rate Band (of £325,000). However, by Mary gifting £100,000 to their son, this will proportionately reduce the amount of Nil Rate Band John inherits from Mary (to £225,000).
When John dies, the savings (still valued at £700,000) are passed to their son. John has his Nil Rate Band of £325,000 and also the balance left of Mary’s Nil Rate Band of £225,000. This gives a total Nil Rate Band of £550,000. Therefore, of the £700,000 in savings to be passed from John to his son, £150,000 will be subject to Inheritance Tax. The Inheritance Tax Bill payable in this situation would be £60,000 (£150,000 x 40%).
The amount of tax payable would be far more if Mary and John weren’t married:
John and Mary – not married
Using the same scenario as above, but assuming Mary and John were not married. When Mary dies, by leaving John £700,000 and £100,000 to her son, this would use all of Mary’s Nil Rate Band. It would mean that £475,000 (£800,000 – £325,000) would be liable to Inheritance Tax. This would equate to a tax bill of £190,000 (£475,000 x 40%). If we assume that John pays this tax bill out of the inherited savings, this will leave him with £510,000 net of the IHT bill. When John dies, the savings (still valued at £510,000 and assuming that John’s son does not benefit from quick succession relief) will pass to their son. John has his Nil Rate Band of £325,000 available only. Therefore, of the £510,000 in savings to be passed from John to his son, £185,000 will be subject to Inheritance Tax. The Inheritance Tax bill payable would be £74,000 (£185,000 x 40%).
As you can see, if Mary and John were married, the total amount of Inheritance Tax payable for their son to inherit the £800,000 of savings is £60,000. However, if Mary and John were not married, the total amount of Inheritance Tax payable for their son to inherit the £800,000 savings is £264,000 – this is over £200,000 more in tax, just because they were not married.
The New Additional Residence Nil Rate Band
From 6 April 2016 married couples can also transfer between each other a Residence Nil Rate Band (RNRB) which is designed to provide an additional Nil Rate Band when passing the main residence to your children or direct descendants. Currently, this gives each spouse an additional £125,000 meaning they can leave £250,000 worth of their property to their children free of IHT; this will increase each year gradually and will be £375,000 by 2021. Potentially allowing a married couple to pass up to £1 million to their children free of IHT.
Several criteria need to be met to qualify for this allowance; however, where available, it is a valuable additional allowance. In fact, for John and Mary in the previous example, assuming they were married, if the £800,000 inheritance was the main residence instead of savings, their son would have had no IHT to pay on Johns death.
Inheritance Tax Allowances For Common Law / Cohabiting Couples
‘You have lived together for 20 years and share all our expenses; we have Wills leaving everything to each other. We don’t have a problem, do we?’
In short, we’re afraid you do have a problem.
Unless you are married, or in a civil partnership you cannot benefit from the ability to leave unlimited assets to each other on first death. You will typically have an allowance of £325,000 each, anything above that will be subject to 40% Inheritance Tax. Furthermore, as the Residence Nil Rate Band is only available to direct descendants, the survivor cannot claim this additional allowance.
This can be devastating for unmarried couples, and we meet couples who have decided not to get married but who have also not fully considered the impact this can have on the first death. Whilst we are still firm believers in the traditional values of marriage, there are clearly some significant estate planning benefits to tying the knot. The generous allowances for Married Couples are dependant on you actually wanting to get married, and for some, this is not an option that they would wish to consider, however significant the tax savings may be.
Beware, New Rules Could Mean New Wills
It was the then Chancellor Alistair Darling who introduced the ability for spouses to transfer their unused Nil Rate Bands to the survivor, on 9 October 2007. Before then it was commonplace for the Wills of married couples to include a provision to pass an amount equal to your Nil Rate Band either to someone else or often to a trust. For those who still have such a provision, they may also be landing your children with an additional tax bill. This is because the new Residence Nil Rate Band is only available if the property is left to a direct descendant and cannot be claimed if you leave the assets into a discretionary trust, even if the children and grandchildren are the intended beneficiaries.
If you have not reviewed your wills for some time, you should do so and where you have set your wills up in this way you should seek advice on how the new Inheritance Tax rules may affect you.
Trust Planning Is Still A Vital Tool – Especially For Second Marriages
Whilst it may be appropriate to revisit some old Nil Rate Band Will trusts, that does not mean there is not a place for trust planning between spouses. One other commonly used form of planning to control the distribution on assets is to create an ‘interest in possession’ trust. This is typically a trust where the income and capital belong to different beneficiaries. In the case of a property the ‘income’ will typically give one beneficiary (known as the life tenant) the right to live in the property and the ‘capital’ beneficiaries (known as the remaindermen) will have the right to the capital value of the property once the life tenant no longer resides in the property, typically on death. In simple terms, this means that a spouse entering a marriage with children from a previous marriage and significant assets can ensure the new spouse is provided for during their lifetime, safe in the knowledge that the children from the first marriage will eventually inherit the capital.
Leaving assets to this type of trust, where the spouse is the life tenant, allows the Nil Rate Band to be transferred between spouses and used on the second death. Furthermore, where direct descendants are the only remaindermen (possible capital beneficiaries), the Residence Nil Rate Band may potentially be available on the second death.
To illustrate the potential benefits of marriage and trust planning, below is the case of Martin and Ruth, clients who we recently helped restructure their affairs.
Case Study: How We Saved £400,000 For Our Clients Martin & Ruth
Martin, 72, and Ruth, 62, have cohabiting been for many years, they have considered marriage but just never got around to it. Most of their assets are owned by Martin and include a house valued at £400,000 and £548,000 of investments and cash. Martin intends to leave his assets to Ruth when he dies, which is likely to be first as Martin is 10 years older than Ruth. On Ruth’s death, she will leave everything inherited from Martin to Martin’s children. If they do nothing the flowing will apply:
|Less Nil Rate Band||£325,000|
|Total liable to IHT||£625,000|
|Total IHT @ 40%||£250,000|
|Less Nil Rate Band||£325,000|
|Total liable to IHT||£375,000|
|Total IHT @ 40%||£150,000|
|Net Estate received by Martin’s children||£550,000|
|Total IHT paid||£400,000|
Paying the large IHT bill significantly reduces the investments available to provide income to Ruth on first death and subsequently leaves less to be inherited by Martin’s children. Also, whilst Martin trusts that Ruth will leave the estate to his children, she could, in theory, vary her Will following his death and may not necessarily leave everything to his children. This could be particularly complicated if, for example, Ruth also had a child from a previous marriage.
We suggested that if Martin and Ruth were to marry, Martin could then consider including an interest in possession trust in his Will, allowing Ruth to live in the house rent free and receive income from the investments for her lifetime. The value on Ruth’s death will then be passed to Martin’s children. Now they are married, Martin can pass everything to Ruth on first death without creating any IHT liability. As Ruth has a ‘life interest’ in the trust, the assets are deemed as having passed to her, even though it is held in trust. She can also benefit from Martin’s unused Nil Rate Band. In addition, now they are married, Martin’s unused Residence Nil Rate band can be passed to Ruth and used on her death. Because the trust names the children as the capital beneficiaries, Ruth cannot alter the eventual beneficiaries which gives Marin piece of mind that his children will inherit everything following Ruth’s eventual demise.
The IHT position now looks a lot different:
100% of estate left in trust is free of IHT, because Ruth is the ‘life tenant’ and will benefit from income (and the right to reside in the property rent free) for her lifetime.
|Less Nil Rate Band||£650,000|
|Less Residence Nil Rate Bands||£350,000|
|Total Liable to IHT||Nil|
|Net Estate received by Martin’s children||£950,000|
|Total IHT paid||Nil|
By getting married and restructuring his will, Martin has ensured that Ruth has an additional £250,000 to provide her with income following Martins death, and Martin has increased the amount left to his children on second death by £400,000.
This demonstrates the significant benefits that both marriage and considered trust planning can provide.