Written by Caroline Foulger, Partner at Hunters Law LLP
Inheritance Tax has never been straightforward, yet many refer to it as a voluntary tax. The current government has other ideas, and the plans to bring most unused pension funds into the scope of Inheritance Tax (IHT) from 6 April 2027 many well be the first step to making IHT unavoidable for many.
The introduction of the transferable nil rate band in 2007 was a step towards the simplification of IHT. In 2017, the residence nil rate band was introduced, a significant shift away from simplicity but a welcome potential additional allowance for those with children, given the nil rate band remained unchanged from the £325,000 threshold set in 2009.
Ten years on, another complication to IHT is on the horizon, but this time it does not provide any allowances and adds more complexity to estate planning.
There are always going to be changes to the IHT regime. It is a marmite tax and a highly political one. It is viewed by many as a further tax on already taxed income or gains. The changes in policy are often triggered by the planning tools that have been developed. Pensions were never intended to be an IHT mitigation measure, but for some, that is what they became. Equally pension freedoms created planning opportunities that were unrelated to tax. For those with families from one or more relationships, the ability to leave your estate to your family with your current partner and your pension, death in service, or life insurance to your family from a previous relationship was very effective planning. It IHT advantages potentially, but primarily it kept estates easier to administer and ensured provision for everyone with as little disruption, awkwardness or conflict as possible.
The changes on the horizon highlight the need to regularly review planning. You can never consider it ‘done’. IHT is a tax that changes periodically but sees a significant shift when it does, not dissimilar to life in general.
The main challenge with this proposed change is that a tax previously viewed as applying to the wealthy is now going to impact many more families, and those who statistically appear ‘average’ in terms of wealth will be subject to a significant tax liability.
Based on the figures released by HMRC in 2022/23, 4.6% of estates paid IHT. The government estimates that including unused pension funds within the scope of IHT will result increase that by 1.5%.
Around 38,500 estates will be paying an increased amount of IHT.
This means the inclusion of unused pension funds within the scope of IHT will potentially result in 6% of deaths resulting in a payment of IHT. The estimated tax revenue as a result of the change is an additional £1.34bn a year from 2028-29.
The nil rate band and residence nil rate band, as well as the taper threshold that applies to this, are to remain at their current levels until April 2030. HMRC’s forecast is that this measure will increase the number of taxpaying estates by 2,900 a year by 2030, increasing the proportion of all UK deaths subject to IHT by 0.6%. HMRC estimates this will result in an additional £355m in IHT in 2029 to 2030.
Based on those estimates, the combination of frozen IHT thresholds and the inclusion of unused pensions on death will result in an additional £1.7bn a year in IHT. On the basis that 42,040 estates will be paying IHT by 2030, on average estates that pay such tax will pay around £40,000 more in IHT by 2030.
Whilst 4.6% of deaths in 2022/23 being subject to payment of IHT may seem like a low proportion overall, of those estates 80% were worth £1m or less.
Based on the Office for National Statistics (ONS) Wealth and Assets Survey 2016-2020, for those aged 55 to 64, on average an individual’s total wealth (including pensions) was £575,000. This exceeds the IHT thresholds available to many by £75,000. However, most people at this average would not consider themselves wealthy.
Inheritance Tax is now going to impact the financially average family. However, the options for planning are very limited for those whose wealth is primarily in either the house they live in or the pension they have contributed to for security in old age.
If you are currently aged 64, the ONS gives an average life expectancy of 85 if you are male and 88 if you are female. Why does this matter? It shows that from retirement at state pension age, the average person with average wealth has around 20 years to plan for the anticipated IHT payment that their loved ones will have to make on their death. Most couples wait until the death of the first of them to consider IHT planning; but for most, this limits the effectiveness of the easier and more straightforward planning. It also shifts this tax from being ‘voluntary’ to being rather inevitable.
An important consideration is what measures families can take to address these forthcoming changes. Strategies that were previously set aside in favour of pensions may again be considered as options for tax planning.
Effective tax planning typically requires the integration of multiple strategies rather than relying on a single solution.
Using the annual exempt amount and small gifts exemption each year is often overlooked, as many consider it trivial or a drop in the ocean. However, if you start early enough, for someone with, say, two children and four grandchildren, this can result in gifting £100,000 from your estate over 25 years with no IHT being due – saving at least £40,000, about the average increase these changes will result in.
Assessing the accumulation of savings is important—if there is surplus income each year, it may be advisable to make gifts from this excess rather than retaining it. Regularly gifting surplus income can provide substantial IHT relief. Implementing these strategies can help mitigate the growth of potential IHT liabilities.
Another option within that category is gift and loan trusts, which may become a preferred option to pension contributions in future. The amount of the loan remains an asset of the estate and can be drawn on – typically 5% per year over 20 years, as it is invested in a bond for income tax reasons. Any amount of the loan outstanding at the date of death is an asset of the estate; however, the growth in value of the funds whilst invested is outside of the estate for IHT on death.
Given current thresholds and the taxation of unused pension funds, life insurance is likely to play an increasingly significant role in inheritance tax mitigation for younger individuals and those with young families.
Wills may become instrumental in IHT planning, with a focus on married/civil partnership couples once again, including nil rate band discretionary trusts in their wills on first death to try to capture valuation discounts for joint ownership of assets on second death and to place assets that are likely to appreciate in value at a rate higher than any future increases to the nil rate band into that structure.
There may also be a desire to capture the residence nil rate band on the first death as well, in case that allowance has been removed by the time of the survivor’s death.
The introduction of a nil rate band for business property relief that is not transferable between spouses, as is the case with the ‘regular’ nil rate band, may mean family businesses have to review their ownership structure to ensure that, as a couple, both utilise their allowances on their respective deaths. Again, a discretionary trust on first death is likely to be back in the toolbox.
There has been a reported rise in people over 55 withdrawing their 25% tax-free pension lump sum (up to £268,275), with some considering giving it away in the hope that once they have survived the gift by 7 years it will be exempt. While this may be suitable for some, the need for care later in life is unpredictable and means such large gifts may not suit everyone.
With that in mind, consideration needs to be given to what care may be required when someone is older and the setting for that. Do they want care at home, or are they likely to be happier in a residential environment? What will the level of care look like? Is it physical or mental health reasons that may dictate the care regime?
If care at home is someone’s requirement, then gifting as part of IHT planning is challenging. If someone’s only asset is their property when they require care, then a funding agreement with the local authority or a lifetime mortgage may be the only way to fund the care. If a residential setting is preferred, the capital in the property is unlocked to fund that care, so gifting in lifetime may be more suitable.
The above highlights how crucial it is that IHT planning is family wide discussion. There are many aspects to it and various factors to balance. Ultimately, though, as most planning relates to gifting, the ultimate decision rests with the person making the gifts.
Planning for IHT can disadvantage the individual not liable for the tax, benefitting those who are. Pensions were an appealing safety net in this regard. Individuals could push the boundaries a little in what they wanted to gift, knowing that the pension was there, nicely outside the scope of IHT, to support them if the calculations turned out not to reflect life as it turned out.
Estate planning is, therefore, more challenging with pension funds within the scope of IHT, and the gifting calculations and cash flow analysis must be more thorough, and paid for fully by clients, to ensure there is a robust plan that has a contingency factored in for care or other unforeseeable expenditure.
As a result of the planning needing to cover more ground, it needs to be openly discussed, which is often difficult even within families, as views on tax can vary widely and many people will have kept their finances private for a long time.
Parents may want to mitigate IHT for their children, but their children are often very accepting of the tax and would rather their parents did not worry about it and remained financially comfortable. On the flip side, parents may view IHT as not their problem to solve, and children may see it as eating into a much-welcome inheritance.
Children may have no need of an inheritance and it will only create a further tax liability for them to solve for the next generation, so they may be happy to forgo their inheritance in favour of their children.
Grandparents may want to help their grandchildren and feel they have already supported their children. They may not, however, know of the financial pressure their children may be under and how helpful an inheritance may be. All of this can vary from child to child.
These matters need to be discussed in an open and informed forum facilitated by advisers, with the resulting outcomes informing the planning options to be considered. Although choices may be fewer, early and phased planning still makes them manageable.
