Many clients have accumulated substantial funds within ISAs
and PEPs over the past 10 years and enjoyed significant tax
breaks in the process.
It's not unusual to see clients with capital in PEPs and
ISAs in excess of £200,000 enjoying the freedom to
switch investments without incurring capital gains tax,
personal liability to tax on dividend income or bond
interest received within the tax sheltered 'wrapper'.
However, as clients get older and inheritance tax (IHT)
becomes an important consideration in their financial
planning, many fail to recognise that capital growth from
any investment held within the estate may ultimately be
worth only 60% of its accrued value. Inheritance tax could
easily apply at 40%, both to the assets themselves and any
growth achieved over the years.
So the 'tax-free' growth from PEPs and ISAs may not be all
it seems...
To illustrate this, let us assume that a male client aged
70 has £200,000 invested in PEPs and ISAs and has no
personal need for the income generated of approximately 3%
per annum gross.
Current life expectancy for a 70-year-old male is just
under 85 years old (source: Faculty and Institute of
Actuaries 2007). Assuming a total annualised return of 7%
per annum net of costs is achieved, in 15 years' time the
portfolio may be worth in the region of £515,000.
If we assume the family home will utilise the nil-rate
band* at the time of death (ie, assuming £600,000 for
a married couple in today's money), the whole of the PEP
and ISA portfolio may be subject to IHT at 40%. The net
value passing to the family will then be just
£309,000.
If instead, the client had chosen to receive income
generated within the PEPs and ISAs and made regular gifts
of this surplus income to the family - for example, to help
with school fees or to increase tax-efficient pension
funding - then the future capital value would be reduced to
just £346,000.
The liability to IHT at 40% on those assets would be
£138,400, leaving £207,600 passing to the
family.
However, income distributions over the period, even
ignoring growth on any gifts made, would amount to
£150,770 and importantly, be free of IHT in the hands
of the person donated to. In total, the family would have
received £358,370 - overall, a saving of
£49,370 and perhaps more importantly, the next
generation would have the use of those funds when they need
them most.
In summary, in certain circumstances and especially as
clients get older, it may be better to 'cap' growth within
the ISA or PEP and to change investment strategy in order
to generate increased tax-efficient income for distribution
to the investor.
Providing this income can be considered for gifting to the
family, there is unlikely to be any eventual liability to
IHT under the 'normal expenditure from income' exemption
and less capital will find its way into the hands of the
Treasury.
Care is required both in terms of recording the gifts and
to ensure they meet the criteria for the exemption, ie,
they must be 'normal expenditure', made from genuine income
and after allowing for the gifts, the person transferring
must be left with enough income to maintain their usual
standard of living. Even gifts out of income will not
qualify for exemption if the person transferring has to
resort to capital for living expenses.
Keeping a record of the gifts made is vital as the 'test'
for the exemption is only carried out post-death.
Finally, where clients wish to retain access to funds or
control of the capital, other approaches such as 'gift and
loan' trusts or discounted gift trusts may offer more
suitable strategies. However, the overriding objective in
all these scenarios is to move future growth outside the
estate.
* Projected to increase at 3% per annum and have increased
Key Considerations:
There are a number of options available to you when it
comes to estate planning, and inheritance tax mitigation.
It is imperative that you consider ALL the options
available to you before you take any action.
ACTION POINT
Calculate what your current exposure is to IHT. Once you've
done this, devise suitable strategies to help reduce the
amount of tax that your beneficiaries would have to pay.
It's advisable to speak to an estate planning specialist as
of all the financial planning areas, this is probably one
of the most complicated.
----------------------------------------------------
Ray Prince is an Independent Financial Planner with
Rutherford Wilkinson plc, and helps UK Resident Doctors and
Dentists get the best deals on mortgages, protection and
investments, as well as helping them achieve their
financial objectives. Just visit
http://www.medicaldentalfs.com to get your free retirement
planning guide. Rutherford Wilkinson plc is authorised and
regulated by the Financial Services Authority.
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