Isabel is a 60-year-old widow with two children and four grandchildren. When her husband died several years ago he left his entire estate to her. Currently, her estate is valued at just over £1m for inheritance tax purposes, with £450,000 represented by the family home.
Isabel meets her adviser to discuss investing £250,000 sitting in a deposit account in an IHT efficient manner. She has made no previous gifts. The account is paying a low rate of interest and to compound matters she is a higher rate taxpayer suffering 40 per cent tax on the interest. She will, however, be a basic rate taxpayer in retirement.
Isabel requires ad hoc access to her investment. Her adviser therefore rules out both a gift trust and a discounted gift trust from an insurance company.
The IHT position
When Isabel dies, her personal representatives will be able to claim a transferable nil-rate band from her late husband. Eligibility is straightforward: transfer is available to survivors of a marriage who die on or after 9 October 2007, regardless of when the first spouse died.
In this case, 100 per cent of her late husband’s NRB was “wasted” (he left his entire estate to Isabel) meaning the NRB on her death can be increased by 100 per cent to £650,000, based on current figures.
Consideration should also be given to current Government proposals, which, if implemented, will effectively increase the IHT threshold for married couples and civil partners to £1m under a new transferable main residence allowance of £175,000 per person.
In short, upon Isabel’s death, there is likely to be an IHT liability, albeit the potential liability may be relatively modest.
After a meeting with her adviser, Isabel decides on a solution comprising an onshore bond “inside” a discretionary loan trust. This proceeds on the basis of three steps:
- Isabel sets up the trust and appoints her two children as additional trustees
- Isabel makes an interest free loan to the trustees
- The trustees purchase an insurance bond with two trustees as lives assured
There is no gift for IHT purposes subject to the seven-year rule. Instead, the outstanding loan balance remains inside Isabel’s estate, with the growth arising inside the discretionary trust where her children and grandchildren are potential beneficiaries.
Regarding the loan, Isabel has options. The trustees could repay the loan to her by taking 5 per cent tax deferred withdrawals from outset. Alternatively, given 5 per cent withdrawals are cumulative, the bond could be left intact with larger withdrawals taken in future policy years (for example, 25 per cent of original investment in the fifth year). Alternatively, the trustees could consider encashing segments to raise funds to repay the loan.
If Isabel decided she no longer needed access to the full outstanding loan balance, she could enquire whether her insurance company provides a deed to waive amounts of the loan. This would provide her with IHT planning without disinvesting from the bond. For example, a waiver of £3,000 could be made to utilise Isabel’s annual IHT exemption. Larger waivers would be subject to the seven-year rule.
The likelihood of a discretionary trust charge is remote. In this case, the trustees will have a full NRB meaning there will only be a tenth anniversary charge if the trust fund exceeds that figure. The trust fund is the bond value less the outstanding loan.
As well as considering the IHT impact, income tax must not be overlooked. Firstly, it should be noted Isabel will no longer be in receipt of bank interest subject to higher rate tax. Instead, the trustees own a non-income producing bond meaning an income tax liability may only arise if a chargeable event occurs and a gain is calculated on it. In that event, the liability would fall back on Isabel while she is alive.
If Isabel dies while the arrangement is in place, the bond will continue if there are any surviving lives assured. Note that it is possible for Isabel to instruct that any outstanding loan balance be cancelled on her death. This would avoid the need for the trustees to encash and repay the loan to her estate. The bond would then be dealt with at the discretion of the trustees who would have the following options after her death:
- Keep the bond running
- Encash in the tax year of death with the gain crystallising on Isabel
- Encash in a subsequent tax year, but beware of trustee tax liabilities
- Assign segments to adult beneficiaries, in which case any subsequent encashment gain would fall on the beneficiary
The discretionary loan trust provides Isabel with a flexible solution offering income tax and IHT efficiency with access to original capital on demand.
Graeme Robb is technical manager at Prudential