The problem: Clients who have maximised their Isa and Pep contributions over many years find they do not need the assets for their own benefit and are looking at the IHT liabilities of their investments.
The solution: For a couple, who are both higher rate taxpayers, who have put the maximum into Isas and PEPs (including single company PEPs) for the last 20 years, and assuming a reasonably modest annual growth rate of 4 per cent, would each now have over £250,000 each sheltered from tax.
As they do not need to access the money at any time, they are simply accumulating investments for their heirs.
The problem comes when either of them dies. Their PEP and ISA tax shelters will immediately cease to exist and the investments within it will pass into the estate.
Inheritance tax now rears its ugly head. If their other assets (such as their house) take up their nil rate band allowances, their Isa investments will be liable for IHT at 40 per cent – a cost of around £100,000 for each of them at the current value.
Lets compare this with the tax they have saved to see if they have made the right decision from an estate-planning point of view.
Let’s assume that the annual growth of 4 per cent is split into 3 per cent capital growth and 1 per cent income.
Over the years, they will have saved £8,962 in income tax at 40 per cent. The total capital growth has been £67,218; assuming they have used their annual allowances elsewhere, this would save £18,821 in capital gains tax (at 28 per cent) if they were to cash in the whole portfolio.
So their tax savings to date are £27,783 – an impressive amount and well worth while. But it would be dwarfed by the inheritance tax payable, as this would fall on the whole amount, not just the profit.
Tax saved = £27,783 but IHT tax = £100,000 each.
Beyond a certain age, it is time to stop putting money into ISAs and start thinking about how to get it out and into an IHT shelter.
One option is to reinvestment in a pension plan, if they are still in a position to make contributions.Like Isas this offers tax-free growth (with the exception of any withholding tax) and the extra benefit of front-end tax relief.
However, if they do not need the money this would simply land them with another tax bill – income tax on any money they take out and, if they opt for drawdown, a 55 per cent recovery charge on any money left in (assuming benefits are crystallised or they die after age 75, with no dependents).
A better option may be an offshore bond. Again, it offers gross roll-up – no tax (bar withholding tax) on returns within the bond and no capital gains tax on switching within the portfolio but with the advantage that it can be put in trust.
If our couple can be quite sure they will not need the money themselves, they can put the bond into a Gift Trust. Any further investment growth would be immediately outside their estate and the gift itself would fall outside the estate after seven years.
Alternatively, a discretionary trust means trustees would continue to have control over both the investment and who could benefit from it.
In this case, the clients should cash in their PEPs and Isas and invest the proceeds in a bond, putting each bond into a separate trust. Each trust would have its own nil rate band so, on the current value of around £250,000, there would be no immediate inheritance tax.
There should also be no periodic charge at the 10-year anniversary, unless the return was large enough to overtake the nil rate band (which is due to increase from the 2015/16 tax year).
To ensure the bonds do not end on their deaths – and thereby cause a chargeable event – they can write them on the lives of others, perhaps the youngest of their beneficiaries.
The trustees can make appointments to a beneficiary at any time, by assigning them segments of the bond. If the beneficiary then cashes in, they would be liable for income tax on any profit at their own highest marginal rate.
Even if the beneficiary was a higher-rate taxpayer, there would still be a gain over retaining the PEPs and ISAs. They would have been subject to 40 per cent inheritance tax on the whole value, whereas the bonds would incur 40 per cent income tax only on any profit made since they were taken out.
Liz Walkington is proposition manager at Legal & General Private Client Solutions