Inheritance tax has often been called a voluntary tax, and this is certainly true if you can gift assets to your nearest and dearest today, survive for the next seven years, and still pay the gas bill in the meantime.
For most of us, however, this is not an option. We need an income from the savings we’ve worked to build up.
So what steps can you take to reduce your family’s inheritance tax bill (IHT)? One solution still works despite the changes to UK tax law in this year’s Budget – the Discounted Gift Scheme. It’s a way to give a cash sum to your loved ones, immediately cutting their potential IHT bill, but keeping an income for yourself.
Two simple steps to beating this 40% tax
The Discounted Gift Scheme has two elements – a life insurance bond, and a trust. Set both up together, and you’ll then hold the bond within the trust. We’ll look at each in turn, and show you how simple – and effective – they can be together.
First, the life insurance bond. This is a lump sum investment, treated as though it’s a one-off premium, paid for an insurance policy. In exchange for a cash deposit, you can invest the policy in a range of managed funds to suit all risk profiles and time horizons, spread across cash, bonds and equities. These funds will be managed by your life assurer, but you may choose to use specialist fund managers as well – including Invesco Perpetual and Gartmore.
In the event of your death, 101% of the cash value of the fund is then paid out to your named beneficiaries. But so much for the basic idea. What makes these policies attractive is their unique tax treatment, particularly when it comes to drawing a regular income from your investment.
With a life insurance bond, up to 5% of your original cash sum investment can be withdrawn every year over a 20-year period without you having to pay income tax at the time. In other words, the tax is deferred. These withdrawals are simply the return of your original capital (20 x 5% = 100%).
Bank-beating returns from your own money
Such favourable tax treatment is hard to match elsewhere in the UK today. For example, a net income of 5% for a basic rate taxpayer requires 6.25% gross. Higher rate taxpayers need to generate 8.33% before tax to enjoy that level of income! Both are demanding returns to achieve from any investment, and they’re way beyond current bank and building society rates.
Take care, however. Choosing a life insurance bond to reduce your family’s IHT liability will enable you to enjoy an income from your investments. But you should be mindful of not draining the cash pot. Ideally, the performance of the underlying investments in your bond should at least replace the cash withdrawn.
Five per cent withdrawals per annum will demand growth of at least 5.26% per year – net of costs – to maintain the capital value of your policy. One way you could accelerate your bond’s annual yield is to hold the policy offshore. An offshore fund pays no tax during its lifetime, so while your policy is invested – all things being equal – the offshore fund will grow faster.
Payback time, however, will come when the bond is cashed. Essentially, the beneficiaries will be subject to both basic rate and higher rate taxation – whichever is applicable to their circumstances. An onshore bond, on the other hand, will have already been paying the equivalent of basic rate tax each year. Only higher-rate taxpayers will be faced with a tax bill when the bond pays out.
UK trust law made simple
What exactly is a trust? It is a legally recognised arrangement which passes assets into the care of a third party (known as the trustees) for the benefit of others (known as the beneficiaries). In the discounted gift scheme I’m advising you consider today, the trust serves as a useful way of legally giving and managing money to your loved ones. It is tax-efficient, and it also gives you the right to attach conditions of your own choosing to the gifts.
The key point to note with trusts is that you can’t change your mind after setting them up. Yes, your right to draw an income from your capital investment is maintained. But the capital you put into trust is gone for good.
This is how it works. You invest a cash lump sum into a bond, and set the desired level of income you wish to draw each year. Remember, you may take up to 5%, but you need to think this through carefully. Once in place, it cannot be changed. (In my experience, most people elect to take that maximum tax-deferred level of 5% income per year.)
When you apply to set up your trust using the Discounted Gift Scheme, you will be underwritten just as you are by any other kind of life assurance policy. But the twist in this case is that your underwriter will split the value of the bond into two parts.
One part is “discounted” according to your life expectancy. That judgement will be based on your age and state of health. This “discounted” part is deemed to provide income for the rest of your life, and so it falls out of your estate immediately for inheritance tax purposes – an immediate saving for your loved ones.
The rest of the bond is then deemed to be a “potentially exempt transfer” (known as a PET). It will fall out of your estate after seven years, provided you’re still alive at that time and so the bond hasn’t been cashed. In the meantime, all subsequent investment growth in your bond will also fall out of your estate immediately.
Let’s look at a simple example to see how this Discounted Gift Scheme can work in practice. Imagine that a 65-year-old man in good health decides that he no longer needs access to spare capital of £100,000. He wants to gift this money into a trust for his grandchildren, but he would like to receive an income from it, too. So he selects an income level of £5,000 per year.
Based on his life expectancy and chosen income of £5,000 per year, his underwriters set an actuarial discount of 52%. In other words, some £52,000 of his initial £100,000 outlay will fall straight out of his estate for inheritance tax purposes. This represents an immediate tax saving to his grandchildren of £20,800 (£52,000 x 40% = £20,800).
The remaining balance is £48,000. This will remain a PET for the following seven years, but it is subject to what’s called “taper relief”. This means that over time, the amount of inheritance tax will shrink. The entire £48,000 will fall out of the estate for IHT purposes after seven years have passed.
An extra £40,000 in just 7 years
If our friend survives for seven years, the entire capital sum of the bond – some £100,000 plus investment growth – will lie outside the inheritance tax net. That creates a minimum IHT saving of £40,000 at current rates. Won’t the grandchildren be pleased!
But what if the grandfather – known as the “settlor” in the trust documents – dies after only three years? Well, he will have saved his beneficiaries at last half the possible inheritance tax due on his gift to them. Not a bad result, and certainly much simpler than the tabloid newspapers would have you believe.
In our example, the policy will pay out on the death of the grandfather. But is that advisable? It is generally best to have more than one life assured when setting up this kind of bond – perhaps including one or more of the beneficiaries, in fact.
Assuring more than one person means the bond can continue beyond the original holder’s life and remain invested. That will give the beneficiaries more time to decide what they wish to do with the proceeds – and when. It may also help get past downturns in the stock market which could reduce the total payout.
Remember, with a trust you can set conditions on your gifts. So you can divide your bond up according to the terms of your Will, and have the appropriate proportion assigned to each beneficiary. If the policy assures the life of other people beyond yourself, then each individual beneficiary can choose whether and when to cash in, or even start taking income withdrawals from the fund for themselves.
A number of life assurance companies offer discounted gift schemes as a packaged product. They include standardised trust documents at no extra cost. But if you are considering this kind of investment, you really should be sure to seek advice from a good independent financial adviser. Have the wording of the trust checked – in draft – by your solicitor.
You can safeguard up to £285,000 today
This year’s Budget tried to close several IHT schemes – or “loopholes” as the Treasury sees them. It also harmonised a range of different trusts into the socalled Discretionary Trust regime. The Discounted Gift Scheme we’ve looked at here is affected by these changes. But the major impact is one of cost.
Money paid into a Discounted Gift Schemes could be subject to a lifetime inheritance tax charge of 20%. There may also be a periodic charge, every 10 years, worth 6% of the current asset values. But these charges, however, only apply to investments over the total IHT exemption. Currently, that’s £285,000. Anything smaller, and your Discounted Trust Scheme will not trigger either the lifetime or periodic charges.
Take note, however. Gifts into other trusts during the previous seven years will be taken into account. And for substantial gifts above the inheritance tax exemption limit of £285,000 there is an alternative type of trust. Called a Bare Trust, it avoids these costs. But the structure of Bare Trusts is considerably more inflexible than the Discounted Gift Scheme.
If you want to find a simple solution to reducing inheritance tax, you can’t beat the Discounted Trust Scheme. Set up your trust today, and in seven years’ time it could save your loved ones 40% tax on up to £285,000. That’s an extra £114,000 in your legacy, kept safe from the taxman.
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