Yahoo Finance How does the new inheritance tax perk work?
New rules that will remove millions of family homes from inheritance tax take effect within weeks. Yet many people could miss out completely unless they urgently review their wills, while it could pay others to start giving away their wealth or even remarry.
From April 5, each individual can claim an additional allowance of £100,000 to offset the sale of a family home on death, on top of their existing £325,000 inheritance tax exemption. This new tax allowance will rise to £175,000 by 2020, allowing a couple to pass on £1m estates tax-free.
However, not everyone will qualify for the new perk. It will not be available to those without children, or to many business owners. Estates worth more than £2m will also be penalised.
Ian Dyall, the head of estate planning at Tilney, the advisory firm, said: “This ceiling is not as generous as it sounds. Where a first spouse dies leaving everything to a partner – such as family home, Isa portfolios, holiday cottage, artwork, other collectibles and jewellery – more individuals than might be imagined will nudge up against it.”
Advisers also warn that wills that provided tax-planning solutions for earlier circumstances are now not only redundant but positively dangerous. Mr Dyall added: “Many traditional estate planning arrangements will no longer work and should be revisited urgently.”
Now that a larger chunk of the family home can be passed on tax-free, advisers also recommend taking a hard look at the most tax-effective ways to take income in retirement when seniors wish to pass on as much wealth as possible to the next generation.
The new regime is complicated, with measures designed to protect those who trade down or sell up altogether. Be warned though: falling foul of the various twists and turns could cost your beneficiaries dear. We steer you through the pitfalls.
How does inheritance tax work?
Currently, spouses and civil partners can pass all their wealth to each other without tax. However, tax may be payable when it comes to cascading wealth down the generations. We can all pass on £325,000 – the “nil-rate band” – before tax is due. Nil-rate bands can also be passed between spouses.
Danny Cox, a chartered financial planner at Hargreaves Lansdown, the investment firm, said: “If the wife dies first and leaves everything to her husband, he can currently give away up to £650,000 tax-free.” The Chancellor takes 40pc of what is left.
What if the wife uses part of her allowance?
She can pass to her spouse any unused allowance as a percentage of the nil-rate band when she dies. As the nil-rate band changes over time, on his death this percentage is calculated against the prevailing nil-rate band and used to lower the tax on his estate.
What is changing?
From April a new allowance, the residence nil-rate band (RNRB), will permit the further reduction of IHT due on the sale of a family home. This new allowance will begin at £100,000 per individual, rising to £125,000 in 2018, £150,000 in 2019 and £175,000 in 2020.
Like the basic nil-rate band, it is transferable between spouses, which permits them potentially to pass on wealth up to £1m without incurring tax.
Who can inherit?
The new allowance is available only when estates are directly inherited by children, stepchildren, adopted children or grandchildren. It will not apply if property is left to nieces or nephews, for example, or brothers or sisters.
It will also not be available when property has been left in trust, which is why wills should be revisited urgently.
Mr Dyall said: “It was common years ago for each spouse to leave their share of a property, up to the prevailing nil-rate band, in trust for their children. But a will that relies on such a trust will not qualify for the RNRB because the beneficiary is a trust, not a child.”
How does the residency test work?
To claim the RNRB, you must leave a property in your estate and must have lived in it as your main residence at some point. A property that has always been a buy-to-let, for example, will not qualify.
What if you downsize?
It is possible to protect the RNRB if you sell your family home to move to a smaller property, or into rented accommodation or a nursing home.
Essentially, if you have sold a property after July 8 2015, you should calculate what percentage of the RNRB could have been claimed had you died after April 2017 and still been living there. This additional allowance can still be used to offset inheritance tax against other assets on death.
Can I give wealth away before I die to avoid tax?
You can give small gifts tax-free. But when disposing of significant assets you may be able to mitigate inheritance tax via what are known as “potentially exempt transfers”. Provided that you survive seven years after making gifts, they are removed from your estate.
After three years, any tax on gifts that exceed the nil-rate band is tapered on a sliding scale.
How can I avoid the £2m clawback?
Estates worth more than £2m will see the new inheritance tax break clawed back, losing £1 of the allowance for every £2 in extra wealth . But many people who do not consider themselves particularly wealthy could be hit by this penalty.
For example, a husband might die with a net estate of property and investments worth £1m and leave everything to his spouse tax free. By the time she dies her assets, including her husband’s bequest, might be worth £3m, rendering both her RNRB and her husband’s redundant.
However, this could have been avoided if she had begun to make lifetime gifts under the potentially exempt transfer rules. For the purpose of claiming the RNRB, any gifts are immediately and completely removed from the estate.
Can I inherit more than one set of IHT tax breaks?
In theory, you can inherit only one nil-rate band and one residential band. But with careful planning it may be possible to benefit from a second spouse’s allowances.
Mr Dyall said: “What we sometimes see is where a widow with potentially £750,000 – or two nil-rate bands – marries a widower who also has £750,000 or two nil-rate bands.
“As each can use only a maximum of two nil-rate bands, we suggest that on the first death wealth up to £750,000 is left to the children and the rest of the estate passed tax-free to the partner. When the second spouse dies, a further £750,000 can be used.”
In theory, this could work for the residential band as well. However, in this case it would have to involve property being left to the children.
Mr Dyall said: “ This would place the surviving spouse’s home at risk. If property has to be left, the children would partly own the home. They may not like their father’s second wife, or could get divorced. This could trigger the sale of the home.”
Why business owners miss out
Business owners are particularly vulnerable to the loss of the RNRB. Most businesses can be passed down the family free from IHT because they qualify for a perk called Business Property Relief. However, even when this is the case, its value will be included in the value of estates for RNRB purposes, frequently pushing them above the £2m hurdle.
Protecting your wealth
Mr Cox said now was a good time to take stock of all financial planning to protect assets from tax.
He said: “The main home is now more tax-efficient, and pensions can also be passed on tax-free. However, Isas, which are free from income tax, do fall into estates for IHT purposes. So it can make sense to run down your Isas before dipping into pensions.” Isas can, however, be passed to spouses tax-free; the process is being simplified in April.
With luck, you will not need to take such extreme steps as the late Duke of Devonshire, who gave Hardwick Hall in Derbyshire to the state in lieu of inheritance tax.
