Inheritance Tax – Keeping Control vs Making Gifts
The age-old dilemma when it comes to passing money to your next of kin and managing your Inheritance Tax liability is whether to keep some sort of control over your hard-earned wealth, or whether it would be better to just gift it outright to your intended heirs.
Although both strategies can mitigate against Inheritance Tax, provided certain criteria are met, they both carry enormously different ramifications. Each have powerful advantages and significant drawbacks that must be considered before even contemplating approaching them, as detailed below:
Making Outright Gifts to your Heirs
- Simple to arrange, minimal planning fees.
- Heirs can benefit immediately from the value of the gift.
- No restriction on the value you can gift.
- Classed as a ‘Potentially Exempt Transfer’ (or PET) – this means that provided the donor survives for 7 years after the date the gift was made, the value of the gift will fall entirely out of the donor’s Estate for Inheritance Tax.
- Furthermore, there is a ‘Taper Relief’ that applies from the third anniversary of the date of the gift. This relief incrementally reduces the Inheritance Tax that may apply on the gift if the donor was to die before the 7 year clock had finished ticking.
- Heirs may not spend the money wisely. You may feel as though your heirs are too young or not in a position to receive a large sum from your Estate. The donor retains no right or control over any gifted funds.
- The funds may become exposed to third parties or become part of a divorce settlement with no protective elements.
- The donor may pass away within the 7 year window and Inheritance Tax may still be payable on the gift.
- There are a number of ways to retain an element of control over money you intend to pass on to your heirs. The most common means of achieving this is via some kind of ‘Trust’ arrangement.
- The donor would make a gift into a Trust. The Trust is then controlled by the ‘Trustees’, who will commonly be the donor themselves, along with a trusted friend or family member and/or professional trustees. This means that the donor can retain control over the funds whilst they sit outside of their Estate for Inheritance Tax.
- The donor can control the flow of money to the beneficiaries of the Trust and better ensure that their gift is spent in line with their wishes.
- A Trust safeguards a donor’s funds against third parties (such as an administrator in an heir’s bankruptcy) or an ex-spouse in divorce proceedings.
- Any investment growth within a Trust is immediately outside of a donor’s Estate.
- A gift into Trust is classified as a Chargeable Lifetime Transfer (or CLT).
- Similarly to a PET, a 7 year clock starts ticking from the date of the gift to remove the value from the donor’s estate, with Taper Relief applying from year 3.
- If the donor survives the 7 years, the full value of the Trust fund exits the donor’s Estate and Inheritance Tax liability can be substantially reduced.
- There are myriad different Trust arrangements, many of which can be rather complex and will require consistent professional advice and guidance. This means that Trusts can be relatively costly to set up and run, as well as requiring active involvement.
- The donor has either limited rights, or no right to the capital invested into a Trust.
- Some Trusts require the Trustees to file annual Trust tax returns and must fulfil HMRC reporting requirements.
- You are restricted with the amount you may pay into a trust, up to your Nil Rate Band. This would be £325,000 for an individual or £650,000 for a married couple or civil partnership. Any gift into Trust greater than these figures would result in an immediate Lifetime Inheritance Tax charge of 20% on the excess.
- Any growth above the Nil Rate Band within a 10 year period may be subject to a periodic tax charge on the excess.
- Much like the outright gift, if the donor passes away within 7 years of making the gift into Trust, then Inheritance Tax may become payable.
To summarise; both outright gifting and forming Trust arrangements can be very effective ways of managing Inheritance Tax. You just have to fully understand them. It is also important to remember that the two aren’t mutually exclusive. They can be used together and this could be a good way of balancing your requirements.
Whatever route is taken, the most crucial thing is that a financial adviser and solicitor are engaged to ensure that it is the right route. Without professional advice significant problems can and do arise, even when something, like an outright gift, can look very simple at outset.