You can reduce IHT with careful planning and by making gifts

“Our spending is relatively modest," says David. "This means that we are able to live off our state pension income of £12,000 a year each and rental income of £42,000 a year before tax from a buy-to-let property worth £977,000. If we need additional income we will sell some of the loans we made via peer-to-peer lender Zopa and then draw on our cash. If we exhaust those assets we will then draw from our individual savings accounts (Isas) and last of all my self-invested personal pension (Sipp).

"We helped our children to buy homes 10 years ago with substantial financial gifts. But should we make further lifetime transfers to our children and grandchildren to reduce the amount of inheritance tax (IHT) they will be liable to after we die?"

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE READERS' CIRCUMSTANCES.

THE BIG PICTURE

Patrick Connolly, chartered financial planner at Chase de Vere, says:

You are in a very comfortable financial position with more income than you need, potentially from a variety of sources. You are also in a position to make gifts to your children.

But you need to determine what your financial priorities are and the specific objectives for your investment portfolio. Are you looking for maximum capital growth or do you want to take a more balanced approach that should provide better capital protection?

You have an interest-only mortgage and cash worth £419,236.71. There is little point in having debt and cash savings if the interest rate you are paying on your debt is more than the after-tax return you are earning on your cash savings. If this is the case, and assuming this is a mortgage on your home, there could be a strong argument for paying off part or all of the mortgage.

You will potentially have a significant liability to IHT after you both die, but you could reduce this with careful planning and by making gifts while you are still alive. You made gifts to your children 10 years ago so these are fully outside your estates for IHT purposes. But before making further gifts, you need to be confident that you will not need any of the money or assets that you are thinking of giving to your family.

There are certain gifts that would fall outside of your estates for IHT purposes immediately. The annual exemption means each of you can gift up to £3,000 a year, or £6,000 each if you didn’t make a gift of this kind in the previous tax year. So, between the two of you, you could potentially hand over £12,000 to your children in one year. After that, the maximum for a couple is £6,000 each year.

What is perhaps more useful if you have excess income is gifts out of normal expenditure. If gifts are intended to be made on a regular basis, come out of income, and do not affect your standard of living, they can be ignored for IHT purposes regardless of their size.

Further gifts in excess of the tax-free exemptions are known as potentially exempt transfers. You need to live for seven years after making these gifts for them to be free of IHT. 

If you die within seven years of making a potentially exempt transfer, and the total value of potentially exempt transfers you make is less than £325,000, the value gifted will simply reduce your nil rate band at the time of your death. So although those receiving the gifts won’t be liable to tax it also means that you won’t save any IHT.

If you make potentially exempt transfers in excess of £325,000 the amount of IHT payable by those receiving the gifts reduces on a sliding scale if death occurs between three and seven years after making the gift.

You are able to give away most assets, including cash and shares. However, it has to be an outright gift from which you can no longer benefit.

Although gifts can be a good way to reduce a potential IHT liability for your heirs, you should also consider other measures such as using available allowances, life assurance, trusts and investing in exempt assets.

If you are not sure what to do you should get independent financial advice.

Shelley McCarthy, chartered financial planner at Informed Choice, says:

Your planned order of withdrawals from your portfolio make sense from an IHT perspective as it is likely the death benefits from your Sipp will fall outside your estate. However, there could be reasons to take benefits from your Sipp due to pensions Lifetime Allowance charges, or because the change in death benefits at age 75 means that your beneficiaries would not benefit from the tax-free cash sum.

There are various allowances that you can use to reduce your heirs' IHT bill, for example your £3,000 annual exemption. You could also use your gifts made as part of normal expenditure out of income exemption. To do this, you need to demonstrate your income and your expenditure for each tax year, and the gifts must be made with the intention of being regular in payment. This surplus can be gifted without impacting your IHT position. 

Given your relatively modest expenditure, whether you make lifetime transfers and gifts probably comes down to your personal preference. Some people are wary of gifting too much as they feel that this would not incentivise their children or grandchildren to work. Gifts to grandchildren can also be a concern if they are able to access them from age 18. However, gifts from grandparents to grandchildren can be very tax efficient, as the grandchildren are able to use their tax allowances. You could also contribute to Junior Isas and start pensions for your grandchildren. Doing this would also make sense from an IHT point of view, so I suggest completing a cash flow forecast to calculate the amount that you could afford to gift.

There are some alternative ways to mitigate IHT such as investing in Alternative Investment Market (Aim) shares that qualify for business property relief meaning they are IHT efficient. 

You have not said what assets you hold in Isas and what assets you hold in Sipps. Although Isas are tax efficient for you, they are not tax efficient with regards to IHT. However, you can now hold Aim shares in Isas. But these are high-risk investments and while your heirs might save 40 per cent in IHT, these assets might lose 40 per cent or more in value.

Gifting the rental properties does not seem like a good option as you are reliant on the income from them and doing this could incur capital gains tax (CGT). If you are reluctant to make outright gifts you could consider trusts, such as gift or loan trusts. 

The value of your estate is significantly over £2m which means that you will lose the additional residence nil-rate band. This allowance, which is currently worth £150,000, is added to your standard nil rate band when you pass property to a direct descendant. However, if your estate is worth more than £2m, you start to lose this by £1 for every £2 of estate above £2m. The residence nil-rate band is due to increase in April 2020 and for a couple saves an additional £140,000 of IHT.

Nimesh Shah, partner at Blick Rothenberg, says:

You are both age 70 and in good health, and get a rental income of £42,000 before tax and state pensions of £12,000 each. This suggests that your combined annual income is £66,000 – or £33,000 each.

Your assets are worth £3,943,380.5, and these can be summarised as follows.

You do not look like you are entitled to the main residence nil-rate band. This is because where the value of an estate is above £2m the main residence nil-rate band is tapered away by £1 for every £2 that the net value exceeds that amount.

You have Sipps but you have not said what the value of these pensions is. So, without taking these into account, based on these combined assets of £3,943,380.5, your IHT liability seems to be as follows.

Total assets: £3,943,380.5

Less combined IHT nil-rate bands of £650,000

Value chargeable to IHT: £3,293,380.50

IHT at 40 per cent: £1,317,352.20

The simplest way to reduce your heirs' IHT is to spend or give away assets, so after the second of you dies the value of your estate is below the combined nil-rate band, which is currently £650,000.

The easiest asset to give away is cash as it does not incur capital gains tax (CGT). You have cash worth £419,236.71 which you could give to your children and grandchildren. The income you receive from your rental property and state pensions is sufficient to cover your living costs so you don't require cash.

You can make exempt gifts of £3,000 each per year, so £6,000 in total. Gifts in excess of the annual exempt amount are regarded as potentially exempt transfers, and the value of the gifts is taken into account for the purposes of IHT if the donor dies within seven years.

Three years after making the gift a taper relief applies which effectively reduces the rate of IHT by 8 per cent applying to the value of the gift. For example, if the donor passes away after five years, but less than six years, after making the gift, the effective rate of IHT applying to the gift is 16 per cent.

From a tax perspective, it may make sense to make the gifts to your grandchildren, skipping a generation. Your grandchildren would be liable to tax on any income generated from the gifted capital. But if they have little or no other income, this income should be covered by their personal allowance which is £12,500 each for the 2019/20 tax year, so they would owe no income tax.

You can make outright gifts to your grandchildren or establish a trust. As a couple, you can make combined gifts to a trust of £650,000 without any upfront IHT charges. The trustees, which could be you while you are alive, can then make discretionary distributions to the grandchildren which could be used for their education.

Over half your assets are stocks and shares. If you decide to gift shares, this would be regarded as a deemed market value disposal for CGT purposes. A capital gain could arise and you would need to pay the associated CGT without having received any cash. You could then make gifts of shares and realise capital gains up to your annual CGT allowance, which is £12,000 for the 2019/20 tax year.

If you make significant gifts now you could look into taking out seven-year term life insurance. The purpose of such a life insurance policy is to provide a cash payment in the event that one or both of you does not survive for seven years and IHT becomes payable. The cost of the life insurance premiums may be lower than the potential IHT, and could provide a level of comfort over tax risk for your family. You would need to take independent financial advice on whether to take out such a life insurance policy.

Your assets do not qualify for any IHT reliefs such as business property relief. Business property relief can be extremely valuable as it can mean the value of the asset is not liable to IHT. So look into divesting some stocks and shares, and reinvesting the proceeds in assets that qualify for business property relief such as certain shares listed on Aim. After you have held the business property relief shares for two years they should not be liable to IHT.  But you should get independent financial advice on these types of investments.

HOW TO IMPROVE THE PORTFOLIO

Patrick Connolly says:

You have £214,000 on deposit with peer-to-peer lending company Zopa. Peer-to-peer lending is popular with investors attracted by the prospect of returns that are significantly better than those available on savings accounts. However, any investment that promises higher returns usually comes with greater risk, so it would be a mistake to compare peer-to-peer loans with bank and building society savings accounts.

And although peer-to-peer lending companies such as Zopa are regulated by the Financial Conduct Authority, investors in the loans aren’t protected by the Financial Services Compensation Scheme. This lack of protection means these investments are unsuitable for those looking for security.

We don’t recommend peer-to-peer investments. But if you are prepared to take on these risks we would suggest keeping your exposure below 10 per cent of your overall portfolio.

You have 38 securities [in addition to peer-to-peer loans, buy-to-let property and cash] , which makes it very difficult to manage effectively. 

You don’t need to take a high degree of investment risk with your investment securities but they are heavily focused on equities. You have eight fixed interest investments but these account for just over 2 per cent of your investment portfolio. And seven out of eight of these are direct bond holdings that provide limited diversification and make the portfolio harder to manage. You could address both of these issues by investing in bond funds such as Jupiter Strategic Bond (GB00BN8T5935), Janus Henderson Strategic Bond (GB0007533820) and Rathbone Ethical Bond (GB00B77DQT14).

You are in a fortunate position, as a fall in the value of your investment portfolio will not affect your lifestyle. However, you are heavily weighted to equity markets, and while your investments have good growth prospects they could be volatile and susceptible to significant losses if stock markets fall.

Despite having 38 investment securities you have about 22 per cent of your investment portfolio in Vanguard FTSE 100 UCITS ETF (VUKE) and Vanguard FTSE All-World UCITS ETF (VWRL), and 6.62 per cent in Fundsmith Equity (GB00B4MR8G82). These are good funds and great core holdings, but you also have many holdings which account for a very small percentage of your investment portfolio so add very little value.

Vanguard FTSE All-World UCITS ETF and Vanguard FTSE 100 UCITS ETF provide broad exposure to global and UK stock markets at a low cost, so are ideal as the core equity exposure in your portfolio.

Fundsmith Equity has also proved to be a superb core holding in many portfolios. It has an exceptional track record and, despite growing to £17bn in size, continues to make strong returns.

In addition to these core holdings, you also have good quality investment trusts such as Fidelity Special Values (FSV), Finsbury Growth & Income Trust (FGT), Mercantile Investment Trust (MRC) and Scottish Mortgage Investment Trust (SMT). These seem like suitable holdings for you.

But because you already have good core holdings via the Vanguard funds, and each of these investment trusts provides further diversification, there is little benefit in having that many investment trusts. So trim the number.

Also question the benefit of having direct share holdings. Considering the amounts invested in each one, they add very little and make your portfolio harder to manage. I would suggest selling these shares, subject to any CGT considerations. Then reinvest the proceeds in more fixed interest and commercial property investments to reduce the risks of and diversify your portfolio.

You could consider commercial property funds, although these can have liquidity issues because it is not always easy to trade assets such as buildings quickly. Ones we like include M&G Property Portfolio (GB00B8FYD926) and L&G UK Property (GB00BK35DV33).

You could also consider commercial property investment trusts that don’t have liquidity problems as they do not have to sell holdings to meet investor redemptions. However, because investment trusts are listed, their performance is more correlated to equity markets.