Beating the (next) Budget: urgent action required

So what now? 

The example of Henry and Jane

Henry and Jane (both resident and domiciled in the UK) are in their 70s.  Their attitude to money has always been cautious.  They are not great spenders.  They helped their children through university and gave them the deposits for house purchase.  They are now concerned for their grandchildren, who will soon face the unsupported cost of further education and the prospect of massive student debt.

Their house, in joint names, is worth £500,000, free of mortgage.

They have money in the bank that would cover funeral and other usual liabilities (other than IHT).  Money in the bank is slowly increasing.

Jane’s ISA holds £300,000. 

Henry’s ISA is worth £400,000.  Henry also has an investment portfolio outside his ISA containing a mix of shares.  The quoted shares are worth £50,000.  The unquoted shares have not done well but are still worth £200,000.

Jane has the state pension and an occupational pension: together they well cover her day to day needs.

Henry has the state pension and a SIPP.  He drew most of the lump sum a few years ago but part of the fund, 15%, is still ‘uncrystallised’.  Henry still does a bit of consultancy, so he has not been drawing as much from the SIPP as he might.  The fund is now £1,000,000 and produces an income of 3.75%.  He was concerned over future care costs, so he has been drawing less than the income of the fund.  The capital is slowly increasing.

The large gifts to the children were over 7 years ago, so have fallen out of account.  Jane and Henry give generously to the family at Christmas and for birthdays.  They have made wills leaving everything to each other, with remainder on the second death equally between children and grandchildren.

The previous position

Under the rules before the budget, the IHT liability on the first death would be £nil.  Spouse relief would exempt the whole estate.  For simplicity, inflation is ignored and it is assumed that cash was equal to debts outstanding.  On the second death the position would have been:

IHT at 40% 100,000.  That is an effective rate of just under 7%.

The new position

IHT at 40% 680,000.  The new effective rate is nearly 28% and the tax burden has increased nearly seven-fold.  *One factor is the loss of Residence NRB because the taxable estate now exceeds £2,300,000.

What to do?

Many commentators are grappling with this.  Some hope that the final rules may be less strict.  We do not yet know if, for example, unquoted shares in a SIPP would qualify for any Business Relief.  For that, we must wait for the legislation.  Bringing an unspent pension pot into the estate for IHT purposes will be very complicated.  The executors and the pension trustees must liaise with each other to calculate the size of the estate for tax, and the proportions in which the tax will fall on different assets.  We have seen, so far, only one concession: funds drawn from SIPP funds to pay IHT on the SIPP fundwill not be treated as a drawing of taxable income.  So an extra charge of up to 45% will be avoided.  Any income drawn later will be taxed as such.

We know that the government wants substantial private investment in infrastructure projects.  That is part of the spur for amalgamating small municipal and other pension funds.  There is no suggestion, yet, that any IHT relief would be available to private SIPP funds invested in infrastructure projects, for example through quoted infrastructure funds (which are in the doldrums at present).

As for Jane and Henry, these seem to be the options:
            Henry to draw the balance of his lump sum by way of UFPLS (see below);
            Henry to ‘ramp up’ his income drawings from his SIPP; and
            Both Jane and Henry to make gifts, as below.

The tax treatment of pensions is quite complicated.  In outline, where a person has not yet drawn the maximum tax-free lump sum, there is a facility to draw it later, but it is not simple.  This is the Uncrystallised Funds Pension Lump Sum or UFPLS regime.  Henry has drawn some of his maximum but not all.  If, say, Henry now wanted to draw another £15,000 tax-free, he would have to apply to draw a total of £60,000 from his fund, of which £15,000 would be free of tax but £45,000 would be part of his taxable income for the year.  Combined with his state pension, that would run him into higher rate tax.  The exact amount he could draw would depend on all the facts.

Apart from that, it would make sense for Henry to change his approach to his pension and draw much more aggressively.  How long will he live?  How long would £1,000,000 (and the income it produces) last?  Since 5^th April 2015 it has been possible to exceed the limits set out by reference to the guidelines published by the Government Actuary’s Department by converting to Flexi-access drawdown.  Thus, depending on his state of health, Henry might draw a substantial part of the fund each year and still not exhaust the fund in his, or in Jane’s lifetime.  If he nominates Jane as the main beneficiary, the fund will escape IHT in so far as it passes to Jane’s benefit. That may give them time to run down the value of the fund to reduce the IHT charge on it.

Henry could use his SIPP fund to buy an annuity.  Then there would be no ‘unspent pension pot’.  Many will feel that to be too drastic, just to save IHT. 

There is a window of opportunity to act before the new rules bite. Henry and Jane should study the (quite complicated) IHT gifts rules.  For now, it will pay to work within the present rules, for as long as they last.

Large gifts

First, if they feel that they will live seven years from now, Jane and Henry should just make simple, outright gifts.  They can safely draw on their ISAs without tax penalties.

Second, depending on the ages of the grandchildren, Henry and Jane could move lump sums into ISAs or Junior ISAs as a ‘float’ towards future tuition fees and the like.

Third, if they are concerned that capital may not be looked after well, they can consider setting up a family trust to protect the money.

Smaller, regular gifts

Apart from capital sums, Jane and Henry could rely on s21 Inheritance Act 1984 in relation to regular gifts, made out of income.  Beware: many are doing just that, so its use may be curtailed soon.  To qualify,

            The gifts must be ‘normal’; and
            Made out of income; and
            The donor must be left with enough to maintain his usual standard of living.

Naturally, taxpayers constantly ‘push the boundaries’ and ‘try it on’.  A wise taxpayer:
            Does not ‘do it too brown’; and
            Maintains good records (see below).

One test of the availability of s21 exemption is the ‘income’.  Executors are often amazed that H M Revenue & Customs expect a high level of evidence to support a s21 claim.  It is set out in their form IHT 403.  They need to know, for the period affected (which will often be the seven years before death) the income of the deceased from all sources, split between:

salary, pensions, interest from all sources, investment income, the income element of annuities and any other income; less the Income tax paid.

Next, the form asks for expenditure over that seven-year period, split between:     

mortgages, insurance, household bills, council tax, travelling costs, entertainment, holidays, nursing home fees etc.

The difference between the net income and the expenditure fixes the maximum total of regular gifts that can be exempted from IHT.

Clearly, if Jane and Henry will keep records, they can more easily judge whether there is ‘room’ to give more out of income.  More importantly, they will save their executors hours of detailed (and probably expensive) research.