Individual savings accounts (Isas) are rightly lauded for their tax efficiency, and with income tax and capital gains tax (CGT) rates rising as the government attempts to plug the UK's huge deficit, they're likely to remain the investor's first-choice tax wrapper. But few people realise that while investments held within Isas are exempt from income and capital gains tax, they are not exempt from inheritance tax.
If you have built up considerable wealth within an Isa - not hard, given that they've been around for more than ten years now - then you should be aware that when you die, that money will form part of your estate.
One Investors Chronicle reader recently wrote in with the dilemma: should he keep his Isas, and run the risks of a high IHT bill for his beneficiaries, or relinquish the tax-free income stream they generate in order to pass more of them onto his heirs?
Using his letter (summarised below) as a case study we asked some financial advisers about the best strategies to mitigate the problem of IHT and Isas.
"Dear Investors Chronicle
I have recently retired having spent the last 30 years following what has now become the standard advice for achieving a comfortable retirement:
• I joined my company's money-purchase pension scheme some 30 years ago and also contributed from any bonuses I received. Just before retirement I moved all of my pension fund into a self-invested pension plan (Sipp).
• My wife and I contributed regularly to Peps (personal equity plans) and subsequently Isas.
• We built up a healthy share portfolio and cash balances in various savings accounts.
This has allowed me to retire at 60 with one third of my income coming from income drawdown from my Sipp, one third from dividends and interest from our share and cash portfolio and finally one third, tax-free, from our Isas.
So far so good, except that our accumulated savings, together with the value of our house and other assets put us well into IHT territory. While I was working this was not too much of a worry as I had life insurance cover of four times my salary from my employer that would have covered the IHT liability, but alas I no longer have this cover.
I have been taking advice from various sources on what we should do about the potential IHT liability and most of the advice seems to conflict with the need to maintain a substantial nest egg to see us through a comfortable retirement. In particular, I am being told that our Isas are no longer tax efficient from an inheritance tax point of view, and that we should get rid of them.
So, what is one to do? Do I set up expensive discounted gift and interest or loan trusts and give away a substantial portion of our wealth in order to avoid IHT, or buy expensive life insurance to cover the potential IHT, or do I just seek to maximise our current assets, enjoy life and leave the problem to my son?"
Don't just discard your Isas
Most advisers agree that there is a trade-off between enjoying tax-free income during your lifetime and then paying IHT on the capital when you die. While an Isa will add to the eventual IHT bill, the consensus is that you should think twice before giving up your Isa and valuable advantage of a tax free income.
"With the limited information that I have available, I would think it is unlikely that I would recommend that the reader and his wife give up the tax efficient Isas already accumulated. They would have paid charges/commission on the way in and if their personal needs grow as they get older, the use of these funds may become more important than saving IHT," says Keith Churchouse, director of independent financial adviser (IFA) Churchouse Financial Planning.
Mr Churchouse adds that if the reader does increase spending then this will have the natural effect of reducing their estate's liability to IHT. "I would also note that 60 is at the earlier end of the scale to make IHT planning a priority. A couple may well live for another 25 years and financial circumstances can change significantly in that time," he adds.
Gift it away
If however you're not spending enough money from your Isa to significantly reduce the future IHT liability, you could think about gifting away capital or the income from them, if surplus.
"I would look at the gift allowances available, such as the £3,000 annual gift allowance which everyone has. If an individual has not used this allowance in the last tax year they can go back one year and use this as well. Both spouses can undertake this operation, gifting away a total amount of £12,000 if their circumstances allow. I would normally recommend that some form of note or letter is provided with the gift to allow the recipient to identify how the amount gifted has been calculated and which allowance it uses," says Mr Churchouse.
If you have excess retirement income you could also make gifts which are immediately tax exempt. This is in addition to your annual £3,000 gift allowance. For the gifts to qualify, you must be able to show that the payments are made out of surplus income - either earned income or investment income - and that they do not reduce your standard of living. "This can be a neat allowance, but only in the right circumstances," warns Mr Churchouse.
You can also make use of a potentially exempt transfer (PET) which allows you to make a gift of any amount without incurring IHT - provided you live for seven years after making the gift.
Transferring to your spouse
Martin Bamford, director of IFA Informed Choice says another option is to transfer assets between spouses. "If the reader dies before his wife, he can pass his assets free of IHT to the surviving spouse. Under the current rules, she then receives his unused nil-rate band to use on her death, which means that more of the value of her estate can be paid to beneficiaries free of inheritance tax," he explains.
The nil-rate band is the amount up to which an estate will have no IHT to pay. Estates up to the value of £325,000 do not incur IHT, but those above this will incur a 40 per cent tax. Therefore if neither partner had used any of their allowance - and the first of the couple to pass away left everything to their spouse the remaining partner would have a nil-rate band of £650,000.
Discounted gift trust
Another possibility mentioned by the reader is selling the Isa investments and putting these assets into a trust wrapper, such as a discounted gift trust. However, Mr Churchouse cautions that this will mean giving up the tax-efficient status of the Isa investment from an income tax point of view, and also accepting the costs associated with establishing the trust investment.
"The returns within the trust, which will typically be within an investment bond, would be less tax-efficient than within the Isa, but possibly not excessively so depending on the individual's tax status. To get the full IHT benefit of a discounted gift trust, however, he would have to survive for at least seven years after making the gift," says Mr Churchouse.
He adds: "If both are non-smokers and in good health they could think about a joint-life last-survivor life assurance policy written in trust (to his son) to protect the estate while thinking about how they want to use their estate in the future. This would at least meet the reader's aspiration to maintain a substantial nest egg for their own needs."
Ultimately, says Mr Bamford, IHT planning is always about making the choice between control of capital and effectiveness. He adds: "If you want one, you cannot have as much of the other. The first step in this exercise is to calculate the likely IHT liability under different scenarios, explore the cost of mitigating this tax and only then it is possible to make a decision on the best action."
