Inheritance tax (IHT) is a painful tax to face. Given that you want to pass on a meaningful legacy to your loved ones, it is little wonder people are interested in ways to legitimately reduce their IHT liability.
Unfortunately, one of the consequences of some approaches to IHT planning is loss of control over your assets. For instance, putting your money into a trust can often reduce your exposure to IHT because, in the eyes of the law, you no longer “own” the assets in the trust.
In this case, you have effectively passed these assets on to someone else and held them somewhere safe prior to your death. This often means, however, that you can no longer control these assets because you technically no longer own them.
Is there a way forward for people who wish to reduce the tax due on their estate, whilst retaining a higher level of control over their assets?
In short, your options are quite limited. However, there are some ideas you might want to consider which we will outline here in this article.
For more information, and prior to making any big decisions about your estate, please consult an independent financial adviser to ensure you are making the best choices available to you.
#1 A closer look at trusts
There are many different types of trust and the rules governing them can get incredibly complicated. Broadly speaking, a trust is a legal arrangement to which you give investments, property and other assets. The people looking after the trust will care for these assets in the interests of a third party, such as a child or grandchild.
As mentioned above, the important thing to note when using a trust is that the assets no longer technically belong to you once you hand them over to the trust. This usually has the advantage of reducing your inheritance tax liability, but you also relinquish control of the assets to the trust.
In a sense, however, it’s worth bearing in mind that you do have a high level of control at the beginning of the process when setting up the trust. You get to decide who will receive the assets in your trust, for instance, as well as how and when. For example, you might decide that your possessions in the trust will pass to your grandchildren once they reach the age of 21.
Alternatively, you could set up a discretionary trust. This hands absolute power to your trustees regarding how to distribute the assets in the trust. For example, it might be that you have left money in a discretionary trust to your grandchildren, which is managed by their parents (your children). The parents can, therefore, decide how and when to attribute the assets.
This obviously means relinquishing more control over your assets than, say, an “interest in possession trust”. This gives your beneficiaries access to income generated by the trust, but not access to the assets themselves (e.g. property or investments). However, for some people, this is an appropriate and desirable course to consider when it comes to their trust arrangements. It depends on your specific financial needs, goals and circumstances.
#2 Thinking about life insurance
This is quite a clever way of approaching inheritance tax whilst keeping a degree of control over your estate. You need to know what you are doing, however, and it might not be right for you.
You can take out a life insurance policy to pay out upon your death, in order to cover your anticipated inheritance tax bill. Provided you write the policy correctly into an appropriate trust, this prevents the policy getting rolled into your estate for inheritance tax purposes.
When you die, the trustee(s) will be paid the sum from the policy. They can then distribute the sum to your beneficiaries according to your stated wishes.
You need to look at this potential course of action carefully, however. Ideally, you should use the help of an experienced financial adviser. Life insurance premiums can be quite high, which can sometimes make it an illogical choice for some people.
You need to be careful to consider the state of your health as well when you take out the policy. If you have a terminal illness, for instance, then HMRC might deem your policy in these circumstances as tax avoidance.
#3 Pensions
Realistically, pensions are going to be the primary, sensible area to explore for most people who wish to keep higher control of their assets whilst reducing their IHT exposure.
With the abolition of the widely-hated “Death Tax” (which levied 55% tax on income drawdown plans passed on to relatives) you can legitimately use a pension to pass more money on to your family after you die. This also avoids many of the complexities involved with passing your assets on to your loved ones via a trust.
If you die before the age of 75 then your pension will not be subject to tax. If you die after this age, then your beneficiaries will have the amount added to their income for the financial year – which might affect their income tax rate.
You need to bear in mind, however, that this tax regime only applies to defined contribution pensions. If you have a final salary / defined benefit pension, then you cannot benefit from these rules. When you die, this pension might pass on to your spouse but it almost certainly cannot pass on any further.
This tax situation has led some people to transfer their final salary pension into a defined contribution pension. However, you need to be very careful if you are thinking of doing this. It can make sense to transfer for some people, but be aware that you will permanently lose some very attractive benefits which are only available to final salary pensions.
Speak to a pension transfer specialist prior to making any big decisions here, as they will help you sift through the jargon and present the appropriate, viable options available to you.