Cheshire IFA — Acumen Investment Partnership. Independent financial advice on investments, tax, pensions and assurance.

INVESTMENT BULLETIN

THE PRIVATE RESIDENCE – IT’S NOW EVEN TOUGHER TO AVOID INHERITANCE TAX

TRADED ENDOWMENT POLICIES

In the first of a series of features and articles, Nick Cosby of the Acumen Investment Partnership answers your questions on Traded Endowment Policies.

The massive rate of increase in the value of property has had many effects. One particularly unpleasant downside is that more property owners will now be caught by inheritance tax when they die. This is because any property that causes the deceased’s estate to exceed the nil rate band – currently £263,000 – will mean that the excess value is taxed at 40%. So, for example, if Mr and Mrs Brown own a mortgage-free house in joint names valued at £500,000, on the death of the second to die there would currently be an inheritance tax (IHT) liability of £94,800. And it is unlikely the position will improve in the future. Over the last 7 years average house prices have increased by 84% yet the IHT nil rate band has gone up by only 18.6%. By 2007 it is estimated that one in eight homes will be in the inheritance tax net.

So for those who do own a property and who are concerned with IHT planning what should they do? Well, there are certain types of planning action that can still be taken. For example: -

1. Planning using the Will

A highly effective form of IHT planning for a husband and wife is for them both to use their nil rate band. This is achieved by them amending their Wills so that the first to die leaves assets of up to the nil rate band to a special trust. Under the terms of this special trust the surviving spouse can benefit from time to time and so, if necessary, the trustees can pay income or capital from the trust to him or her and so maintain financial security. On the second death, the assets in the trust will not count as part of the surviving spouse’s estate thus currently saving IHT of up to £105,200 (£263,000 @ 40%) at that time.

So what assets can be left to this trust on the first death? Well, preferably if husband and wife own investments in their own name, then the first to die could leave these assets to the nil rate band trust. The trustees could then pay income and capital in the trust to the surviving spouse from time to time.

But what if their major asset is a house? Well, then it will be possible for both husband and wife to use the house in this planning. First the house would need to be placed in the form of ownership known as tenancy in common to prevent the house automatically passing to the surviving spouse on the first death. Then each spouse would make a Will leaving all of their interest in the house to the surviving spouse on the first death but also establishing a nil rate band discretionary trust. The Will would give the deceased’s executors power to choose what assets they should use to satisfy the nil rate band legacy. These would include an IOU or a charge on the house which can be paid off when the surviving spouse dies.

It is of vital importance that if this planning route is used, the trust that comes into existence on the first death is actually operated as a proper trust. Otherwise the Inland Revenue may refuse to agree the desired IHT consequences.

2. Gifts of other assets

It may be that husband and wife have other assets that they can gift in such a way that they enjoy some form of income without a gift with reservation arising. The pre-owned asset rules apply in a different way to investments (as opposed to land). This means that schemes based on lump sum investments combined with trusts still work very effectively to avoid the gift with reservation rules and pre-owned asset rules. But this will, however, be of little help to those couples whose main wealth consists of their private residence. For those people, it may be best to consider insuring the liability (see below).

3. Covering the IHT liability

There is a very effective way for a couple to deal with the anticipated IHT liability on the second death without the worry and concern of gifting the private residence. This is for them to simply take out a joint lives life assurance policy that will pay cash on the second death – precisely when the IHT liability will arise. In order to ensure that this cash pay out is itself free of IHT the policy is effected under a special trust – a flexible trust – with the initial named beneficiaries being the people who will suffer because of the IHT liability – namely the beneficiaries under the Will who will usually be the children.

So on the second death these beneficiaries will get a cash pay out which can be used to meet the IHT bill and avoid the forced sale or mortgage of assets at that time. This cash pay out will be free of income tax and IHT. Indeed, the only gifts involved will be the premium payments on the policy which will often be an excellent way of using the £3,000 annual exemption (£6,000 in total for a couple) and the normal expenditure out of income exemption – gifts made on a regular basis out of income that do not affect the premium payer’s standard of living are free of IHT.

ACTION:
If you wish to reduce your inheritance tax bill, or tax effectively provide for an inheritance tax liability, please contact us to arrange a consultation.

HELPING CHILDREN FINANCIALLY – WITH THE AID OF THE TAXMAN!

These days, children need more financial help than they did in the past. This is especially in the area of house purchase and with the cost of a university education.

Over the past year or so parents, grandparents or anybody else who wishes to provide financial assistance to a future student, cannot fail to have noticed the amount of press coverage given to higher education and the ballooning costs associated with it.

The following statistics will give many people cause for concern: -

So what can be done to deal with this problem? Well, one course of action would be to pay costs out of income or available capital on a “pay as you go” basis. However,
this can be expensive! A much better option is to save in advance. And if the choice is to save, the earlier saving starts the better.

The Government has tried to kick-start the idea of saving for children by introducing the Child Trust Fund (CTF). CTF accounts will be available from April 2005 and children born on or after 1 September 2002 will be eligible.

All children in the UK will have at least £250 paid into a CTF account, with children in families receiving the full Child Tax Credit receiving a minimum addition of £250. A further Government payment will be paid into the account on the child’s seventh birthday.

Anybody, but usually parents or grandparents, will be able to contribute up to £1,200 a year into a CTF account. All growth and income in the CTF account will be tax free – and the full value of the investment fund will be available to the child at age 18 – to use in any way he or she chooses!

Whilst all this is good news, it should not be forgotten that a CTF account will only be available for children born on or after 1 September 2002, £250 at 5% p.a. will only grow to about £600 over 18 years, a child may not qualify by virtue of having been born “too early” and at age 18 all of the invested funds will be paid to the child – the parent has no control over this.

So, with or without the Child Trust Fund, a parent is likely to need to save or invest if that parent wishes to make a meaningful contribution to a student’s higher education costs. In this respect, there is no substitute for parents establishing savings plans early in a child’s life to accumulate cash that can be used for the benefit of the child at a later date. And, of course, when setting up such savings programmes, it is well known that the more the plan’s tax efficiency can be improved, the greater the likely investment returns. So what tax efficient structures can a parent utilise? Here’s a brief résumé of three available options:

An ISA can generate tax-free income and capital growth. However, apart from one minor exception, ISAs cannot be effected by children or indirectly for a child’s benefit. ISAs are very flexible and can be encashed at any time, which makes them ideal as investments that can be used for a child’s future wellbeing.

Clearly, because of the tax advantages, it makes sense to maximise investment as soon as possible, especially in view of the fact that the annual investment limit is set to reduce from April 2006 to £5,000.

2. Collective investments and bare trusts
A bare trust is a very useful way for a parent/grandparent to use the annual CGT exemption of a child/grandchild. In essence the trustees of the bare trust could invest in growth-oriented investments within a unit trust or OEIC and hold the investment on behalf of the child. In the meantime, any capital gains arising on encashment of units or shares will be taxed as the child’s, thus meaning that his or her annual CGT exemption of (currently) £8,200 can be used.

That’s not all; once the investment has been held for 3 years, taper relief is available, ranging from 5% relief with 3 years’ ownership to 40% with 10 years’ ownership. So at current rates gains of £13,666 in a tax year could be crystallised tax-free on an investment held for 10 years.

As will be appreciated this could be a very attractive way of regularly releasing slices of tax free capital each year to meet the costs associated with higher education. But don’t forget that as the trust is a bare trust, the child can unravel it at age 18. The parent needs to be comfortable with this.

The Government is considering changing the CGT tax rules on bare trusts so that in cases where the settlor is the parent of a child beneficiary, capital gains are taxed on the parent. However, even if this change does occur, it is only likely to affect gains realised before the child is age 18 or married and so should not affect planning for the costs of a university education.

3. A single premium bond subject to a flexible trust
If the parent or grandparent required more control over the use of an investment, they could invest in a single premium bond on a joint lives last survivor basis. The bond would be held subject to a trust with the child as the designated beneficiary but with the parents, as trustees, having the power to change beneficiaries should they so wish. The investment made into the trust would be a potentially exempt transfer for IHT purposes.

If cash was required from the trust to meet some of the costs of higher education, the trustees could use their 5% annual withdrawal facility to make regular encashments with no tax at that time.

Alternatively, the trustees could at that time appoint benefits absolutely to the adult child/grandchild equal to the required university costs. The bond or an appropriate number of individual policies within the bond could then be assigned to the beneficiary – no tax charge arises at this time. The subsequent encashment of the bond or individual policies would trigger a chargeable event and any gains that arise will be taxed on the child beneficiary, which would in many cases result in no tax charge.