Before we look at ways of structuring asset ownership to minimise inheritance tax, it is essential to address one common misconception. People will often talk about tax evasion and tax avoidance (management) simultaneously. Tax evasion is an illegal method of minimising your tax liability, while tax avoidance is a legal method of reducing your potential tax liability. When it comes to shielding your assets from inheritance tax, there are several options to consider.
Understanding Inheritance Tax
Currently, the inheritance tax threshold stands at £325,000, which means that on your death, theoretically, you will pay tax at a fixed rate of 40% on assets above this level. At first glance, the £325,000 threshold may seem slightly ambitious for the average estate. However, to put this into perspective, as of March 2023, the average home in the UK was worth £258,115. When you also add in potential additional assets such as property and investments, it is not difficult to breach the basic £325,000 threshold.
Note: For inheritance tax purposes, HMRC will use the net value of your estate, taking into account debts such as mortgages.
Exceptions to the rule
If you leave assets above the inheritance tax threshold to your spouse, civil partner, charity or a community amateur sports club, there is usually no tax charge. Where you leave your home to your children (including adopted, foster or stepchildren) or grandchildren, there is an additional allowance available known as the residence allowance. This provides further protection of £175,000 from inheritance tax, thereby increasing your cumulative threshold to £500,000.
It is also important to note that if you are married or in a civil partnership, and your estate is worth less than the threshold, any unused allowance can be added to your partner’s threshold when you die.
Diminishing inheritance tax threshold
The UK government announced plans to freeze income tax thresholds in the recent budget. This avoids increasing income tax rates, but most of us will pay more tax because wages should grow, even if less than the recent high inflation rate. A similar tactic has been used with the inheritance tax allowance, which was frozen at £325,000 in April 2009 (until April 2028). To put this into perspective, using the Bank of England’s inflation rate calculator, if the inheritance tax threshold had just increased in line with inflation, it would stand at £493,614 as of January 2024 – a shortfall of £168,614.
The Role of Pensions in Estate Planning
Before we look at pensions as part of estate planning, it is crucial to appreciate the primary tax benefits of a pension:-
- Pension contributions are gross, up to £60,000 per annum
- Pension assets are shielded from income and capital gains tax
The cumulative impact of not only gross contributions but also tax-free income and capital gains can be significant over a prolonged period. These benefits are further enhanced by the fact that usually, your pension assets will not form part of your estate. As they will not contribute to the £325,000 threshold, they can be a highly tax-efficient means of shielding your assets from inheritance tax.
Expression of wish/nomination form
There is a common misconception that your will controls all of your assets and the naming of beneficiaries. This is not the case with pension fund assets because these are outside of your traditional estate. Consequently, it would be best to name the beneficiaries of your pension assets using an expression of wish/nomination form. This should be lodged with your pension provider and will be considered upon your death.
Surprisingly, it is up to the pension scheme administrator who will inherit your pension fund assets. Obviously, they will consider your expression of wish/nomination form, but they are not legally obliged to fulfil this instruction. However, only in exceptional circumstances would you expect a pension scheme administrator to effectively ignore your wishes.
Pension beneficiaries and taxation
While your pension assets are not generally classed as part of your estate for inheritance tax purposes, there are other issues to consider:-
- If you die before your 75th birthday, then typically, pension assets will be free of income tax to beneficiaries
- If you die on or after your 75th birthday, your heirs will likely pay income tax at their marginal rate
There are exceptions to the rule concerning different types of pension schemes, and it is essential to clarify this with the pension provider.
Trusts as a Tool for Asset Protection
Regarding estate planning, trusts can be advantageous in managing assets and minimising inheritance tax liabilities. In essence, when you transfer an asset to a trust, this asset is then effectively owned by the trustees. Therefore, the trustees will manage the assets for the benefit of the beneficiaries under conditions you dictate when the trust is created. But, more importantly, as you do not “own” the assets, they are outside of your estate regarding inheritance tax.
There are seven basic types of trusts which are:-
- Bare trust
- Interest in possession trust
- Discretionary trust
- Accumulation trust
- Mixed trust
- Trust for a vulnerable person
- Non-resident trust
The bare trust is the most basic type of trust, where the beneficiary will become entitled to the assets on their 18th birthday in England, Wales and Northern Ireland or their 16th birthday in Scotland. It is vital to take advice from your financial planner about setting up a trust, what type of trust and instructions for the trustees.
Potential inheritance tax liabilities
As you might have guessed, when it comes to taxation, nothing is ever straightforward, the devil is always in the details. Consequently, you may not be surprised to learn that there are some potential inheritance tax liabilities when it comes to setting up a trust.
Seven-year rule
If you die within seven years of transferring assets into a trust, the assets will count towards your estate, and there may be inheritance tax to pay. However, if you live for at least seven years after the date of transfer, the assets will not be drawn back into your estate when calculating any inheritance tax liability.
Setup and exit charges
When you set up a discretionary trust and transfer assets, you usually pay a 20% inheritance tax charge if this is above the inheritance tax nil rate band. For example, if you transferred £425,000 into a discretionary trust today, then you should expect to pay a £20,000 charge:-
- Transfer: £425,000
- IHT allowance: £325,000
- Taxable element: £100,000
- Tax charge @ 20% = £20,000
Each trust is revalued every ten years, and if valued in excess of the inheritance tax allowance, an additional 6% inheritance tax is charged on the excess. There is also a similar pro-rata charge when the trust is closed or funds are withdrawn. However, there will be no tax charge if the transfer, or the 10-year valuation, is below the inheritance tax allowance.
As you can see, the subject of inheritance tax and trusts is complex. Therefore, you must take professional financial advice.
Strategies for Shielding Pension and Trust Assets from Inheritance Tax
There are obvious pros and cons when using pension funds and trusts to mitigate future inheritance tax liabilities. The benefits of pensions include:-
- Income and capital gains are free of taxation
- You can contribute up to 100% of your annual earnings, but there is only tax relief on the first £60,000 a year
- You can backdate pension contributions subject to annual earnings and membership of a pension scheme
- Pension fund assets are generally outside of your estate for inheritance tax purposes
The downside of using a pension scheme to reduce your inheritance tax is simple:-
- Funds won’t usually be available until your retirement
- If you die on or after your 75th birthday, there may be tax liabilities for the beneficiaries
When looking at trusts in general, the main benefits are:-
- Ownership of the asset is transferred to the trustees and deemed outside of your estate
- Upon setting up the trust, the trustees will be advised of your wishes and how the trust should be managed for the beneficiaries
There are a number of potential downsides when looking at a trust which include:-
- You no longer own or have control of the assets within the trust
- The trustees have a legal obligation to put the beneficiary’s needs before all others
- As a consequence of the seven-year rule, some assets may be drawn back into your estate
- Transfers valued in excess of the inheritance tax allowance may attract a setup charge
- If the 10-year trust valuation exceeds the inheritance tax allowance, there could be an additional 6% charge
- Depending on the value and type of trust, there could be an additional pro-rata exit charge
Ironically, most pension assets will be held under a trust structure to separate client pension assets from the pension administrator’s assets.
Conclusion
When using pension funds and trusts to protect your assets, reduce your inheritance tax liability and maximise inheritance for beneficiaries, there are many issues to consider. First, it is essential to note that while there may be inheritance tax benefits, the beneficiaries may still pay income tax on inherited funds.
You must take professional advice concerning inheritance tax planning, as errors today could prove costly further down the line. There’s also the fact that tax regulations change regularly, and you may need to take action to protect your assets and manage future liabilities.
It’s important to appreciate potential tax liabilities further down the line, looking to protect and manage your income and assets on an ongoing basis. If you require advice and guidance on asset protection, please contact us, and we can discuss the situation in more detail.