Personal Finance – How to keep family heirlooms.

Inheritance tax is often referred to as a ‘voluntary’ tax, in that you don’t need to pay if you are careful. If so, why are bereaved relatives still pouring £2.25bn or more into the Treasury’s coffers each year in inheritance duties?

The reality is that while inheritance tax is avoidable, it needs planning to keep every penny out of the taxman’s hands. IHT is charged at 40% of the value of an inherited estate above a ‘nil rate’ threshold, currently set at £242,000.

Stuart Grennan, of Wolverhampton-based financial advisers Torquil Clarke, says the first place to start cutting IHT liabilities is to make a will.

In fact, making a will is important for other reasons:

– If you are co-habiting, your partner is not automatically entitled to any part of your estate.

– If you marry, any existing will is automatically revoked.

– If you have stepchildren, if you say only that money is to go to your children, then only your birth children will benefit.

– If you have made separate wills with different bequests and do not specify otherwise, in the event of a sudden death of both spouses at once, the younger spouse’s will takes precedence. The older spouse’s is ignored.

So what should you do if considering a will? Unless your financial affairs are extremely simple (and most people’s aren’t) steer clear of off-the-shelf DIY wills: when it comes to IHT planning, they don’t cut the mustard.

For that, you need expert advice.

For example, many couples will have their wills structured so that, in the event of one partner’s death, any assets will be passed to the surviving spouse. Grennan says: ‘This is a needless aggregation of an estate, and can be avoided by using a discretionary will trust on the first death.

Take an example where Mr and Mrs Smith each have £500,000. ‘Mr Smith dies and could pass his estate to Mrs Smith, but she probably doesn’t need £1m. Instead, £242,000 – the amount of the nil rate band – can be paid into a trust for the children or other relatives. The excess, £258,000, can go to the wife.’

IHT is not charged on transfers between spouses. This scheme means IHT will ultimately only be paid on the wife’s estate on her death – £758,000 in this case, compared to £1m if the trust had not been set up.

Even if a discretionary will trust has not been established by the time of the first death, it is not too late. The widow or widower has a two-year window to create a ‘deed of variation’, changing the terms of their deceased partner’s will to benefit their children.

Clearly, money could simply be given away to children or other family members. The downside is that any gift made within seven years of the donor’s death still counts as part of the donor’s estate. Thus it will still be taxed, albeit on a sliding scale.

Some gifts are exempt, even if they are made during this period. These include:

– wedding gifts of up to £5,000 to each child and step-child, £2,500 to each grandchild, and £1,000 to anyone else

– maintenance payments to ex-partners and children under 18

– other gifts up to a total of £3,000 in any tax year

– small gifts of up to £250 to any number of people

– donations to UK charities.

After this, the main task faced by potential IHT payers is to reduce the value of their estate before they enter the last seven years of their life.

This leads to another problem, as Kevin Minter, financial planning manager at the David Aaron Partnership, in Milton Keynes, explains: ‘When you are in your 40s or 50s, it is very difficult to say you won’t ever need those assets. Consequently, people tend to look at IHT planning in their 60s. By then, it may be too late.’

Most people looking to give away large sums of cash to their children tend to set up a trust. There are a whole range structured to meet differing needs. A donor can opt to be a trustee, but this is pointless from an IHT perspective as the assets are counted as part of the donor’s estate.

John Battersby, personal tax partner at KPMG, offers an alternative: agricultural property or farmland is exempt from IHT, providing it was bought at least two years before the owner’s death. Similarly, shares in unquoted companies become exempt after two years.

Invariably, the hardest asset to avoid IHT on is the family home. This is increasingly important, as the #242,000 threshold will not cover much in London, or in many other parts of the country.

One way is to grant half the value of the property to a child on the death of the first parent, on the unwritten proviso that the remaining parent can continue to live there. Beware, however, that the Inland Revenue may not accept this is an IHT-exempt transfer.

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