Mark Devlin: Getting ready for the residence nil rate band

Mark Devlin

Fred and Daphne, aged 70, are comfortably retired and have £20,000 of excess pension income building up in their bank account. They also own a house worth £850,000 and have £75,000 in their bank accounts.

As they have been building up excess income, last year they jointly placed £300,000 of their accumulated wealth into a discretionary loan trust. Their children and grandchildren are potential beneficiaries of this trust.

A discretionary loan trust was selected on the basis they may need access to this capital should they need long-term care. They also want to be able to pay for a care home of their choosing, rather than accept the local authority’s choice should they have no assets. They are keen to ensure they live out their final years in comfort.

Because of their long-term care concern, Fred and Daphne have a very fixed position in terms of making significant disposals to potentially reduce their inheritance tax.

They have two children and would like to leave as much as they can to them. They are also aware the residence nil rate band does not begin until the next tax year and this will start at £100,000 per individual. This will be phased in until the 2020/21 tax year when it will reach £175,000. They have sought guidance from an adviser on the best course of action.

The tax position

Without taking any action, in terms of the tax position should both Fred and Daphne die in the current tax year, their joint estate would have IHT to pay of £230,000 on the second death. The IHT bill from 2017/18 to the 2020/21 tax years, when the full £175,000 of the taper takes effect, will be £171,900, £174,427, £177,603.59 and £183,701.33 respectively. This assumes the excess income remains static but their property grows at 4 per cent per annum and the bank account pays 1 per cent interest after taxation.

The main residence nil rate band will be transferable where the second spouse or civil partner dies on or after 6 April 2017, irrespective of when the first person died.

It is important to remember before the assets can be distributed probate must be granted. As there is an IHT bill, HM Revenue & Customs must issue a receipt confirming this has been settled before assets can be distributed. Therefore, the children will need to pay the IHT on assets they have not yet received. If they do not have funds available they may need to borrow this over the short term.

The solution

As Fred and Daphne are not willing to give up access to the loan capital, writing this off is not an option, so their adviser looks to use their excess income to solve their IHT issue. The adviser recommends a one-year level term assurance for £60,000 on a joint life second death basis to cover the period before the residence nil rate band is due to begin in 2017/18.

In conjunction with this the adviser has recommended a £170,000 whole of life plan on a joint life second death basis. This covers the remaining IHT on the estate.

For this to be IHT-effective both protection plans will need to be placed in trust so the proceeds are outside Fred and Daphne’s estate. This will ensure any benefits paid from the plans can be paid straight to the beneficiaries without the need for probate and assuming the children are the beneficiaries they will have the funds to settle the IHT bill.

As the premiums are funded by Fred and Daphne’s income, this alleviates the build-up of excess income they presently have.

Another fundamental benefit is that by funding the protection plans from excess income, the premiums paid are IHT-exempt. This could be complicated if the premiums are being paid from capital as they become a series of chargeable lifetime transfers.

This approach will not only cover the phasing in of the residence nil rate band, it will also deal with the IHT bill on Fred and Daphne’s whole estate and their descendants will benefit from the full value of the wealth they have accumulated.

It also ensures the IHT bill can be settled quickly and removes the burden on the children of potentially raising the funds during what will already be a traumatic time.

While the residence nil rate band is not being introduced until next year, it does need to be factored into any IHT planning being undertaken this tax year. It may also require any previous planning undertaken to be reviewed in light of the changes.

Mark Devlin is technical manager at Prudential