Protecting those you leave behind

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Ian Jefferies looks at how advisers can help an increasing number of clients to mitigate estate planning and inheritance tax liabilities through protection policies

It is a natural desire to work hard throughout life and to build wealth with the hope of passing some of it on to the family – but the government’s decision to freeze the inheritance tax (IHT) threshold at £325,000 until 2017/18 has resulted in an increasing number of ‘ordinary’ hard-working people finding that they fall into the IHT bracket. 

Estates will pay tax at 40% above that level, or double that level for couples. This can be compared with the US where the threshold currently stands at $5.34m (roughly equivalent to £3.2m), and yet is still the source of considerable political controversy.

HMRC recently reported that IHT receipts during the 2013/2014 tax year totalled a massive £3.4bn, and the Office of Budget Responsibility predicts this will keep rising with an expected total of £5.8bn to be collected by the Treasury in 2018/19. OBR forecasts suggest the number of families required to pay IHT will rise by an astonishing 35% this year to 35,600, increasing to 43,800 next year and an incredible 54,500 in the tax year 2018/19.

It is therefore unsurprising that an increasing number of people are looking into their estate planning options. 

This is one of the biggest areas of opportunity for advisers to help clients avoid the impact of this very unpleasant tax that will hit families during a time of grief. In fact, more than half of financial advisers have seen a heightened number of enquiries regarding estate planning options over the last two years, and this is only set to continue with rising house prices and increasing economic recovery.

So what are the legitimate ways clients can ensure they are passing on as much as possible to their loved ones?

In the first instance, annual gifting allowances should be used where possible. Gifts totalling up to £3,000 per individual per tax year are allowed as part of an annual exemption, with previous years’ unused exemption able to be carried forward to a future tax year. Additionally, people can also make further one-off gifts of £250 to as many individuals as they like. 

Next, it’s important to consider clients’ investments. Clients may be better off using a pension over an ISA or collective during the wealth accumulation phase. If they do not need flexible access to their savings, using a pension is a suitable savings vehicle, as it falls outside of someone’s estate for IHT purposes – if the money has not been touched – meaning that if someone dies during their working lifetime, the contributions they have made are likely to be returned to their family as a lump sum.

Trust option

A further useful estate planning strategy for clients is ensuring assets are held within trust. Although many assets held in trust are included in the seven-year IHT gift window, once this has passed, those assets will often fall outside the UK IHT bracket, as they are no longer part of someone’s estate, provided the settlor is not a beneficiary of the trust. 

Additionally, because the assets are held in trust they are not subject to probate (the process of determining who can administer the estate) and can therefore be accessed quickly. 

Trusts are a long-established estate planning method, although the use of multiple discretionary trusts has been subject to government scrutiny lately to ensure the practice is not being abused. 

A new law to be introduced in June 2015 means an individual will have one IHT nil‑rate band applied across any new discretionary trusts they establish. Previously individuals could set up as many trusts as they liked, each with their own band; under the new rules any amount in trust above £325,000 will be subject to a 6% tax charge every ten years. 

However, with IHT set at a rate of 40%, this could still work out to be a valuable saving. Additionally, people could consider using a different type of trust, such as a Bare trust, if they are certain of whom they wish the money to go to from the point of creation and do not need flexibility to change the arrangement. 

Even after considering all the possible options above, and despite all the best tax planning, many individuals will still find that they fall into the IHT bracket. With the addition of government scrutiny on the use of trusts, it is even more important for advisers to consider the full spectrum of tools.

Whole-of-life policy

One further option for advisers, which their clients may not have considered in the past, is to set up a whole-of-life (WOL) insurance policy, written in a suitable trust. This provides a guaranteed payout upon death and, because it is written in trust, will usually sit outside the inheritance tax net, thereby improving its tax efficiency. 

Additionally, a protection policy written in trust can be  covered by the normal expenditure out of income rules, meaning it would be exempt for IHT purposes, so is not subject to the seven-year IHT gifting period.

Guaranteed rates mean certainty of cost and certainty of money being available to pay the tax bill. Setting the plan up under a suitable trust means speed of payout on death, as the sum assured is available to the trustees without having to wait for probate to be granted.

An example can illustrate the benefits of choosing a WOL policy. A 60-year-old non-smoking client with an estate worth £500,000 could leave on death an IHT bill of £70,000 (40% of the value of his estate over the IHT threshold). If he sets up a WOL insurance policy, with a lump sum payout of £100,000, this would cost him £154.45 a month. 

If the same client were to invest this amount monthly with the aim of achieving £100,000, a consistent return of more than 7% would be needed. This assumes life expectancy of a further 22 years as indicated by the government mortality rates. However, we all know that death can occur at any time, which reinforces the value of a simple WOL solution.

One common objection to this approach is that some clients are not prepared to pay the price of guaranteed WOL rates. The need for and issues of IHT do not go away with this objection, so how can advisers provide an alternative solution that provides the same IHT mitigation benefits but offers lower costs in the early years?

Alternatives are available in the market including rolling-term cover, such as that offered by Old Mutual Wealth. This involves a ten-year renewable plan with premiums guaranteed. The plans are renewable throughout life with no maximum expiry age and no further underwriting.

For a 60-year-old couple, with an IHT liability of £256,000, a rolling-term policy to cover that amount could involve cheaper premiums for the first two terms of ten years, only becoming more expensive than a WOL plan once the couple are in their early 80s, which is roughly equivalent to their mortality point. 

IHT remains a controversial tax, eating into the savings clients wish to leave behind for their loved ones. With the number of estates falling into this bracket rapidly increasing, it is more important than ever for people to understand the tax planning opportunities available to them – and for advisers to know where the opportunities are. Protection policies remain a simple, cost and tax-efficient solution for clients. 

Ian Jefferies is head of protection at Old Mutual Wealth

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