Skipping a generation could be more tax-efficient

As a result of rising property prices, thousands more families face being hit with a 40 per cent inheritance tax (IHT) bill if their individual assets surpass the £325,000 threshold.

At the same time, vast numbers of young people are struggling to get on the property ladder at all.

But current conditions are creating an opportunity for older generations to help out younger relatives by passing on assets to their grandchildren rather than their children, according to Paul Killik, partner of Killik & Co.

He argues that legacy planning has not kept pace with the changing structure of the family unit. Increased longevity has resulted in many families boasting four generations, but parents still tend to pass assets to children, rather than to grandchildren or great-grandchildren, he explains. This is despite the fact that often their children's generation benefited from free university education, ready availability of property and the generous pension schemes that are not available to more recent generations.

"It makes sounder financial sense for those approaching later life to pass assets a generation or two further down the family tree, than to direct children - and, if they can afford to, they should do so earlier as well," says Mr Killik.

The main reason for this is, with youth on their side, young people will be able to benefit from the power of compound interest on any investments they receive. Furthermore, passing on assets to younger generations could be a way of minimising the amount of IHT your family will have to pay overall.

"If assets are passed down each generation the family is hit each time a member of the oldest generation dies. By skipping generations, the risk is vastly reduced or eliminated," he explains.

Grandparents already give generously to their grandchildren. New research by online investment company Orbis Access found that UK grandparents gave £6.4bn to grandchildren aged under 18 in the past year. But most of this giving was short-term rather than long-term financial planning, despite the fact that 40 per cent of grandparents believe debt or financial struggles are the biggest threat to their grandchildren's future happiness.

Sarah Lord, managing director of Killik Chartered Financial Planners, says this is a trend that is starting to change. Her clients are increasingly concerned about the long-term questions of how their grandchildren will get on the property ladder or fund their retirement.

She says: "It's becoming more common as the baby boomer generation gets more established in their retirement, and understands the costs of what they need in their own retirement, that they're starting to think about the potential impact IHT of 40 per cent would have on their estate and, therefore, ways in which they can help today rather than at the time of their death.

"And that seems to be a big shift in mentality as well. People these days seem to be of the view that their children or grandchildren need help today, so if they can afford to do it they'd rather help now than letting them wait until their death."

Patrick Connolly, certified financial planner at Chase de Vere, also thinks we can expect to see grandparents passing on a greater portion of wealth to their grandchildren. He points out that increased life expectancy means people will often be leaving assets to their grown-up grandchildren.

"As people live longer, your grandchildren are likely to be adults, whereas in the past when people didn't live as long, their grandchildren were likely to be children. So you're actually gifting to somebody who's hopefully a responsible adult and will make the right decisions in terms of what they do with that gift."

But he cautions individuals who are considering giving away some of their assets while they are still alive to make sure they can afford to do so. In particular, they need to factor in the possibility that they may need to pay for a lengthy stay in a care home towards the end of their life.

He says: "The starting point for grandparents is not to give away anything that they might need themselves; that's the danger. What you don't want to do is compromise your own lifestyle in order to benefit through tax efficiencies or just because you want to help out younger generations. So step one is to make sure that when you do give anything away, you're comfortable you can afford to do it."

A way to help you decide what you can afford to give is to recognise whether you need income or capital in your retirement years, and give accordingly.

Gifting income

If you think it will be easier for you to gift income to younger members of your family there are several ways to do so. For example, you can gift up to £3,000 a year, IHT-free. This rises to £6,000 if you didn't make a gift of this kind in the previous tax year. A married couple giving for the first time could therefore hand over £12,000 to their grandchildren in one year. After that, the maximum would fall back to £3,000 per person. Grandparents can also give £2,500 to their grandchildren for a wedding or civil partnership.

You could make IHT-free gifts of money on a regular basis - if they come out of your income and do not affect your standard of living.

"For those with larger incomes this can make a significant difference to their potential IHT liability and allow them to make ongoing investments or savings on behalf of their grandchildren," Mr Connolly says.

There is also the option of giving away assets, including cash and shares, as tax-free gifts, known as potentially exempt transfers (PET). David Cameron's receipt of £200,000 from his mother was a PET. PETs have to be an outright gift from which you can no longer benefit and donors need to survive for seven years after making the gift for it to be deemed fully IHT exempt. However, the tax payable is reduced on a tapering basis from year three onwards.

The one thing that you cannot give away in this way is your family home if you continue to live there, unless you pay rent at a market rate to your heir.

But Mr Connolly believes that with many parents already owning properties and grandchildren struggling to get on the property ladder, we could see an increasing number of people leaving properties to their grandchildren.

Gifting property

If you're planning to pass property on in this way, currently you will be hit with an IHT bill, at a rate of 40 per cent, if the value of your property is over the nil-rate band (NRB) of £325,000. However, from 2017 onwards you can benefit from an extra NRB that applies only to residential property. Although initially worth £100,000, by 2020-21 this residential NRB will be worth £175,000 per individual. The residential NRB can only be used where the property is being inherited by a direct lineal descendant, which includes step, adopted and foster children. But if the net value of your estate is above £2m the additional main residence NRB will be tapered away by £1 for every £2 that the net value exceeds that amount.

Residential nil-rate band

Source: HM Revenue & Customs

You could also make use of a trust to pass on your property or other assets to your grandchildren. Ms Lord says, despite falling out of favour in the past, more of her clients are turning to trusts to gift assets on their death to children or grandchildren.

She says: "Typically, a discretionary trust would be used by grandparents, so there's discretion as to who the beneficiaries can be. That's really useful if the family is still growing because you can describe the beneficiaries simply as 'the grandchildren' and as the family grows all the grandchildren can be included and be treated equally."

Gifting your pension

The new pension freedoms and resulting changes to death benefits have also opened up the possibility of passing on your pension to younger generations. Ms Lord says she has noticed increased interest from people looking to change their nomination of beneficiaries - or expression of wish - on their pension, including skipping a generation.

The significant reduction of death taxes on pensions means it often makes sense for people to draw retirement income from other sources and leave their pension alone to be passed on, says Mr Connolly.

"With the new freedoms you can take out what you want, when you want, but actually if [your pension] stays there it's benefiting from tax-efficient growth and not subject to IHT," he adds. "If, in this case, the grandparent dies before age 75 then their pension can be passed through to future generations with no IHT charge."