Inheritance Tax is charged at 40% on estates in excess of £325,000. There are many and varied methods of mitigating such a tax.
Investors have built up significant tax-free savings within ISAs only to find they may later need to either gift the money away, or transfer out of the plan and into a trust (putting outside your estate) to minimise any Inheritance Tax liability.
Trusts carry some inflexibilities, many of which investors are fine with, but some can be restrictive.
However, tax developments have allowed for investors to maintain their ISA tax free status but make use of potential Inheritance Tax savings.
An investor can transfer their current ISA into an AIM ISA. AIM means Alternative Investment Market. The UK government gave these shares a specific tax break to encourage investment into ‘up and growing’ companies.
An investment manager creates a portfolio of these stocks which then benefit from current Business property relief.
Business Property Relief currently sits at a very attractive 100% exemption, and so every penny in an AIM listed ISA would qualify for 100% Inheritance Tax relief after just two years. This differs significantly from the normal trusts and larger gifts which take seven years to make their way outside your estate.
The biggest difference between a gift into a trust or an outright gift to family is the time it takes to gain a tax advantage.
Often misunderstood, the money placed into an investment that qualifies for Business property relief is actually never outside the estate. It simply benefits from a 100% relief on the tax. If that relief was taken away later or reduced, the money is fully chargeable at the relevant rate of Inheritance Tax.
AIM portfolios are a pretty efficient tool to minimise Inheritance Tax on any money, whether in an ISA or not, particularly if the donor is elderly or in ill health, as the speed of relief is five years quicker. Another benefit is access to the Capital. Unlike trusts, you have immediate access to the money and can take withdrawals.
The downsides to it are the diversification in assets you are investing into. AIM shares tend to be smaller, less liquid and potentially more volatile in risk. Liquidity of a share is important as they can potentially be more difficult to sell, particularly when markets turn sour.
AIM portfolio managers tend to focus on the higher end of the market however, reducing that illiquidity and volatility.
On death, the executors of the estate can then liquidate (sell) the shares and they pass into the estate for distribution. They can also leave the money invested enjoying its tax-free growth and income.
There is another interesting tax break available in an ISA that is often misunderstood.
If your spouse/civil partner were to pass away you inherit a ‘strange but nice’ one off additional ISA allowance. It is either the value of the ISA on death, or when it is closed, whichever the greater.
So, if they had a fund of, say £75,000 rolled up into an ISA, you would be able to use your own ISA allowance of £20,000 for the year plus an additional £75,000.
Additionally, you could leave the account open for the maximum three years and then have three years of growth on the capital, and on closure within that three-year period, the closing value would be the amount you could use as the allowance. For example, the ISA value on death was £75,000 and the total value at the end of the three years was £90,000. In that year, your ISA allowance is £110,000.
Whilst these are the tax rules to navigate with your Independent Financial Adviser, remember to really look at the choice of manager carefully. Tax tails shouldn’t wag investment dogs, and a tax efficient, but poorly performing ISA does not make sense, particularly in light of the wide-open choices we have available out there.
Remembering back to a recent column, for example, where we showed that £100,000 invested into the top performing pension versus the lowest performing pension had a difference of over £900,000 return in a twenty-year period.
For more content like this visit our Savings and Investment channel.Last modified: June 10, 2021