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Tax measures fit the nil

Aegon’s Elaine Cruickshank says taxpayers around the current nil-rate band should act now to mitigate IHT

Elaine Cruickshank: Tax and trusts manager Aegon
Elaine Cruickshank: Tax and trusts manager Aegon

Chancellor Alistair Darling fixed the IHT nil-rate band at £325,000 for the tax year 2010/11 and the four subsequent tax years in the 2010 Budget. This means that, currently, single people, unmarried couples and divorcees (where their former partner is still alive) will have an IHT liability on their death if the total value of their respective assets exceed £325,000 in value.

In the Finance Act 2008, we saw the introduction of legislation allow-ing spouses to transfer any unused IHT nil-rate band on the first death to the surviving spouse. This means that on the death of the surviving spouse, their personal representatives may claim a maximum of two nil-rate bands if the nil-rate band was unused on the first death.

What this means is that in the case of married couples, there will be an IHT liability arising if the total value of their combined assets exceed £650,000.

Where the value of an individual’s estate currently totals the IHT nil-rate band of £325,000 and if the assets they own were to grow in value by 5 per cent over the next five years, then they would be worth £414,791 in 2014/15.

This would result in an IHT liability of £35,916 (£89,791 x 40 per cent) on their death. It is therefore clear that individuals whose assets are around the current nil-rate band should consider taking measures now if they want to mitigate this potential future IHT liability.

Given the fact that the Conservatives have announced that they propose to increase the nil-rate band to £1,000,000 if they win the election, some individuals may currently be reluctant to make an irrevocable gift for IHT purposes.

Loan trusts can provide payments to supplement an individual’s other income in retirement

Instead, they could consider a loan trust as a possible solution as this arrange-ment would cap the individual’s future IHT liability as any growth on the underlying trust fund would be outside their IHT estate from the start of the trust. With the loan trust, the settlor lends the trustees money to create the trust and the value of the outstanding loan forms part of the settlor’s IHT estate.

In other words, it is not a gift for IHT purposes.

The trustees can make use of the 5 per cent tax deferred allowance, offered by an investment bond, to make loan repayments to the settlor each year, thereby supplementing their retirement income. The value of the outstanding loan will reduce year on year as these repayments are taken and spent, leading to IHT savings.

To illustrate how this would work in practice, John, a 73-year-old widower, has assets in excess of the nil-rate band and his wife’s nil-rate band was fully used on her death. He decides to create a discretionary loan trust with £150,000 to mitigate some of his IHT liability and to make some provision for his children. He has pension income of £22,750 and wishes to supplement this from this loan trust. By creating the loan trust, he will receive loan repayments of £7,500 each year from the trustees and can have access to the loan capital.

Given the turbulence in the financial markets of late, the trustees chose to invest the £150,000 in an onshore bond on John’s life. They chose to invest in a product that offers guarantees as this will ensure that they can meet the loan repayments to John of £7,500 for 20 years, even if the fund value drops to zero. Under the terms of the product, there is also a guarantee that on the death of the last life assured, that is, John, the bond will pay out the higher of:

  • 100.1 per cent of the cash-in value
  • The original investment less the loan repayments taken to date or
  • The highest recorded fund value less the loan repayments taken to date.

The trustees find this an attractive option as it means that they won’t be held pers-onally liable for any shortfall if the underlying funds should underperform. John dies in year 11, when the fund value is £45,000. The highest recorded fund value was £195,000 at the end of year three. The table above shows a comparison between an onshore bond with and without protection.

As John has taken back 11 years worth of loan repayments and spent these, he has achieved IHT savings of £33,000 (£82,500 x 40 per cent).

With the protected option, the capital held for the beneficiaries is also outside John’s estate leading to further IHT savings of £18,000 (£45,000 x 40 per cent). The protection itself has generated an extra £45,000 for John’s dependants.

In summary
Loan trusts can be a useful method of providing payments to supple-ment an individual’s other income in retirement while at the same time offering the benefits of capping an individual’s IHT liability and achieving IHT savings.

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