Keiron Root tracks down the most effective ways of keeping your estate out of the hands of the taxman

This is the time of year when investors turn their thoughts to tax planning, and an increasingly significant area involves planning ahead to mitigate the effects of inheritance tax (IHT).

This year, however, there is an added degree of uncertainty, since the Budget is not due until 22 April, well into the new financial year.

As Mark Green, head of tax and estate planning at Legal & General, points out, ‘We are in an interesting situation, with the Budget deferred to late April. Normally, there is a window after the Budget for IHT planning, which can be useful because the government has a habit of introducing changes that can affect IHT planning quite significantly, a good example being the changes that were introduced in 2006 affecting trusts.’

Greater flexibility
Green observes that ‘The latest innovation was the introduction of transferability of nil-rate bands. A lot of people will have achieved that anyway by drawing up the right wills. But transferability has caused its own problems because you need to have all the paperwork available and it can be a very complex process.’

Bob Fraser, senior wealth adviser at Towry Law, warns that ‘A lot of people, including some solicitors, now argue that there is no need to make full use of the nil-rate band on first death. In many cases, that may be valid, but not in all cases. An obvious one is where someone has been widowed before, as you don’t have access to an unlimited number of transfers. So you would definitely want to make full use of the nil-rate band on first death in those circumstances.’

He adds, ‘A second example is where one of the spouses has previously been divorced. They may want to benefit the children of a previous marriage and that will also require the use of nil-rate bands.’

Green agrees: ‘It is a good idea, but a potential worry is that such transferability can encourage people to think that they don’t need to do any more IHT planning, which is often a big mistake.The government doesn’t want to be seen to be directly taking money out of people’s pockets, but they will need to raise money to pay for what they are putting into the economy at the moment, so it will be interesting to see what they do in regard to IHT.’

Shifting sands
Indeed, one of the problems with IHT planning is that you are rarely sure what the government is going to do next. Jason Walker, senior manager at adviser AWD Chase de Vere, reports that ‘What we typically do is look at legislation and try to diversify IHT planning across different bits of legislation, so if there is a change in one area, it won’t affect the whole of your planning. This came to the fore with the changes in the 2006 Budget, which came out of the blue.’

So where should you start with IHT planning? Walker argues that ‘The first step is to look at the individual’s total assets and ask questions like: are they married or are they already widowed? We would encourage investors to make use of all the gifts available, the £3,000 per year allowance, regular small gifts of £250 a month, gifts to children in respect of marriage and so on, but remember that these gifts have to be total.You have to properly give the money away.’

Indeed, gifting is at the core of IHT planning. As Matt Phillips, investment director at BDO Stoy Hayward IM, observes, ‘IHT planning is a lot easier than it used to be. These days it is basically about making gifts and making sure that they don’t give rise to a chargeable event. It is now very simple because of the way that the government has changed the rules in recent years.’

Normal expenditure
He adds, ‘One method that is very underused is making gifts out of normal income. These are not potentially exempt transfers (PETs), so there is no seven-year clock, but it has got to be regular and it has got to be out of income. But there is no upper limit, so for example, you could use it for long-term savings into a pension for a child or grandchild, so long as you can prove you don’t need that income.’

Paul Wright, director of investment management at Zurich’s UK life division, suggests that ‘The starting point with IHT planning is making a will. This should be the first thing you should do. Dying intestate is not ideal, unless you don’t mind giving money to the government. The next thing is to ensure that you make the most of the various allowances you have available to you.’

Lee Smythe, director of financial planning at Killik & Co, agrees that ‘The first step is to make use of the various allowances, gifting, gifts in respect of marriage and so on. But often one of the big problems that people have with IHT planning is knowing how much they can afford to give away.’

The trust option
Once the basic allowances have been used up, you will almost certainly have to consider some form of trust arrangement if you want to move substantial amounts outside the IHT net.

Lee Smythe points out that ‘Putting money into trusts enables you to retain control or receive an income. Of course, there are still difficulties because opting for the trust route means that you are going to have to give up either control of the money or access to the income.’

Neil Chadwick, technical marketing manager at Royal London 360°, suggests that ‘The key questions you have to ask yourself are: do you need an income and can you afford to give everything away?

If you are in a position to genuinely give it all away then you can set up a gift trust, of which there are two versions – an absolute version, where the gift is a PET so there is no IHT to pay providing you survive seven years from the date of the gift, and a discretionary version, where the gift is a ‘chargeable lifetime transfer’, so there will be an IHT liability if it is over the IHT allowance, currently £312,000.’

Bob Fraser argues that ‘If you are in the situation where you don’t need access to the capital or income now but are worried that the surviving spouse might need it later, then you can put it into a discretionary trust with the other spouse as the beneficiary and trustee. So if they need the money, they can receive it, but if not, then it can go to other beneficiaries.’

He adds, ‘If there is no need for the income generated by the capital, but they require the possibility to access the capital at some point – for example to fund long-term care – they can use a loan trust, where the growth is immediately outside the trust but they can have access to the capital later on.’

Neil Chadwick adds, ‘With a Discounted Gift Trust, the settlor takes out an insurance bond that is written in trust. You have to be under 90 and able to be underwritten for a whole-of-life product. Then, depending on how much income you want and your life expectancy, a gift trust can be structured to provide an income.’

Paying the piper
But what if you aren’t able to give it all away? Lee Smythe says, ‘Beyond mitigating the liability, if you are looking to retain access to your money, or if you can’t gift all your liability away, you can look at ways that will provide for your heirs, and this usually means some form of insurance-based scheme. This means there is a policy that will pay out so that they have actually got the money to pay the liability.What a lot of people don’t realise is that you have to pay the tax before you can inherit the estate, and by using these insurance-based schemes you can have a sum available for this purpose.’

He adds, ‘We see many people who have a lot of income they don’t need. For example, they have an investment portfolio but are also receiving a pension and they can make use of that income to make gifts or to fund a wholeof- life policy to meet that liability. This can also be an effective way of transferring part of a pension fund to the next generation, without it going either to the government or to an annuity provider.’

Being realistic
Lee Smythe observes that ‘IHT planning is normally quite specific to individuals. You need to get a good feel for their requirements. You have to come up with something that suits their individual circumstances and the likely requirements for their money for the rest of their lifetime, but that also works in terms of dealing with IHT.’

He adds, ‘You can come up with an ideal IHT-saving solution and present it to a client, who then says they are not going to do that because they might need the money. In the end, a lot of people don’t do any IHT planning because they are more worried about running out of money before they die than they are about paying IHT.’

And Mark Green cautions, ‘Proper tax advice is absolutely crucial these days, as tax legislation has become so complicated. Otherwise, investors who try to plan to limit the effects of IHT on their estates could get themselves into situations that could cost them quite a lot of money to get out of.’