Planning ahead can help to reduce IHT

“Managing my properties is increasingly stressful and residential properties with long-standing tenants are very illiquid," says Marcus. "So I expect to sell some of these in the next couple of years and give away significant amounts of the proceeds. But this means that my income will decline, so I will want certainty of income from my investments. 

“I have stopped taking my State Pension so its annual payout value is increasing. But we do not plan to downsize our home, and I continue to pay the costs of a holiday home I bought for my children, to whom I have also made other gifts.

"My children do not have good pension provision and will not be able to enjoy the same standard of living as we do unless they inherit the family house. But I estimate that our assets will incur inheritance tax (IHT) of at least £1m, and am concerned that their lack of liquidity will make it difficult for our executors to raise cash to pay it. I would like to try to reduce my heirs’ potential IHT bill so I will give away significant assets over the next two years.

"Because of our pension and property income I have not seen the point in diversification. I have been investing for 30 years, and was reasonably confident in taking risk because we do not rely on our investments for income.

"But I was unnerved by the market sell-off in April, and spent a number of weeks looking at my portfolio many times a day. Holdings such as National Express (NEX), which I considered to be low risk, experienced substantial share price falls. But I would like our investments to make a return of 8 per cent a year for the next two years.

"My wife and I have worked very hard and made sacrifices to build up our income and assets, and I do not have the appetite I thought I had for substantial risk. I am not good at taking losses and tend to only do this at the end of the tax year if I have capital gains (CGT) tax to offset. I have a very high allocation to cash because of my lack of confidence and a significant income tax bill to pay in January.

"I don’t invest in things I don't understand, or companies such as Amazon (US:AMZN) as I am convinced that at some point they will be broken up or highly taxed."

Marcus and his wife's portfolio

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

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

This year’s big losses on equities have shaken your confidence. But Christoph Merkle at Aarhus University found that after big losses in the 2008-09 financial crisis most UK investors were not as distraught as they feared and their losses were less detrimental than they thought they would be. And the coronavirus pandemic was a genuinely unforeseeable event. Unlike a stock market fall caused by over valuations or an ordinary downturn, it is not an event you could have foreseen. So don't kick yourself for not seeing it coming.

However, many investors overlook the fact that a high dividend yield is very often compensation for something such as cyclical risk –  the danger of doing badly in downturns. This is why house building and mining stocks have traditionally offered decent yields, and Royal Dutch Shell (RDSB) and National Express were among the companies that did badly during lockdown.

If I were a long-term buy-and-hold investor, I would share your scepticism about big US monopolies as in the long-run they get laid low. But the long run is not the same as the short. Avoiding companies such as Amazon and Apple (AAPL:NSQ) means missing out on strong performance.

And equities are very risky. For example, so far this year the FTSE All-Share index has fallen about 18 per cent. Historic volatility suggests that this is only around a one-in-six event. The cause of this loss is unusual, but the scale of it is not, so perhaps you were under estimating risk.

If markets bounce back, as they do, or when the coronavirus is contained, higher-yielding stocks might thrive. The upside of carrying cyclical risk is that stocks do very well when the threat of recession falls. But this is only one possibility.  

Jeremy Croysdill, client director at Brown Shipley, says:

If you are in good health and keeping a keen eye on your long-term objectives, you can plan during your lifetime to ensure that your family’s assets are working tax-efficiently and organise them well for your heirs.

Before you start IHT planning it important to ensure that your will is valid and up to date. Dying intestate or with an invalid will causes lengthy delays for your family, and assets may not be passed on accordance with your wishes. Also consider writing Powers of Attorney so that your assets can be managed on your behalf if you become incapacitated.

An estate heavily weighted towards illiquid assets such as property can cause problems for your executors and increase the IHT due after your death. They cannot use assets from the estate to pay the tax. HM Revenue & Customs requires payment of IHT at the end of the sixth month after someone’s death, but only grants probate – access to the assets of the estate – after receiving the tax owed.

An exception is assets that take time to sell such as property, shares and securities, and businesses. The executors can elect to pay the tax due on these in instalments over a period of up to 10 years, but there will be interest to pay on the amount of tax outstanding. If there isn’t enough cash available, the executors can pay the tax out of their own pockets or take out a short-term loan.

The information you’ve provided suggests that your estate's potential IHT liability is around £2m. I suggest taking financial advice to get an accurate picture of the liability and to find out what options you have for mitigating it after the second of you dies. No IHT is incurred by transfers of assets between spouses when the first spouse dies.

Making gifts could be a key part of your IHT mitigation strategy. They don’t have to be one-off, large amounts. If you have surplus income each year, you could gift this away under the regular gifts out of income exemption for IHT, and it immediately falls outside your estate. To make use of this exemption you need to show that the gift forms a pattern – for example, monthly or yearly – and that it doesn’t impact your standard of living. It is important to make a record of the gifts for your executors to help with the administration of your estate.

You became eligible for your State Pension before 6 April 2016, so you should continue to benefit from higher interest rates while you defer drawing it. Alternatively, you could draw your State Pension and gift away the income as it won’t impact your standard of living.

If you can afford to make regular gifts it could also address your concern that your children don't have adequate retirement savings. You could put money into your children and grandchildren’s private pension funds. Pension contributions benefit from a 20 per cent tax break so, for example, if you pay £800 into one of their pensions the child will get basic-rate tax relief on the contribution, increasing the amount to £1,000. If any of your children are higher-rate taxpayers they are entitled to 40 per cent tax relief on the contribution via their self-assessment tax return.

If you make larger gifts as a result of selling properties these will be treated as potentially exempt transfers (Pets) for IHT purposes, and are only fully outside your estate if you live for seven years after the date of the gift. IHT on a gift tapers away the closer you get to the end of the seventh year, and a gifts inter-vivos insurance policy can mitigate the tax liable if you die during this period. This is a relatively inexpensive type of term assurance policy. 

Any previous gifts to your children and the ongoing costs that you pay on the holiday home are also treated as Pets. 

However, you should prioritise your future financial security over making gifts. If you work with an adviser to build a lifetime cash-flow plan it will help you to work out how much you can give away without affecting your lifestyle.

You plan to sell your rental properties, but are concerned about replacing the income you get from them. You could invest the proceeds of the property sales into investments that qualify for Business Relief. These schemes invest in the shares of UK unquoted trading businesses in areas such as renewable energy, long-term contracts with local authorities and new technologies. After you have owned the shares for two years the investment falls outside your estate for IHT purposes. You can mitigate IHT with these kinds of investment without having to gift assets and they will pay you an income if necessary. You could also sell them if you need to raise cash at a later date.

However, these types of investment are higher risk, so normally we only recommend them as part of an overall strategy to mitigate IHT.

Shelley McCarthy, managing director at Informed Choice, says:

Having a financial plan would help you to understand the risk you actually need to take to achieve your goals and how much you can afford to gift away without impacting your future lifestyle. 

The value of your properties, cash, NS&I Premium Bonds and investments suggests that your estate has an IHT liability of over £2m. As your estate is valued at well over £2.7m the Residence Nil Rate Band does not apply. If you made gifts to your children within the last seven years they need to be added to the value of your estate, after any allowances.

Gifting is one of the easiest ways to reduce an IHT liability. There are various allowances that you can use, such as the annual allowance of £3,000 and gifts made as normal expenditure out of income. However, gifting the properties and assets outside individual savings accounts (Isas) could incur a significant CGT liability. And gifting or selling the buy-to-let properties will reduce your income.

Trusts can play a part in estate planning and are not necessarily as complicated as people often think. They are particularly useful if you want to retain control of the gift, generate an income for yourself, or retain access to the capital via a loan trust.

You need to know whether you can afford to make gifts outright, what tax this might incur and what income you are giving up. A starting point would be to be clear on your expenditure. Also consider the order in which you make the gifts, and set up the loans and trusts, and consider what gifts have been made previously.

If you have a high enough risk appetite there are investments that qualify for Business Property Relief after being held for two years such as Aim shares. However, these are often small start-ups with a higher risk of failure and in return for a 40 per cent reduction in IHT you might make a bigger loss. However, you can hold Aim shares within Isas.

Trying to achieve a high return in a short period of time is a very risky strategy and could result in a substantial loss. There is also a high level of volatility and uncertainty in markets at present. Also, investing with a view to achieving high returns could increase the value of your estate and your heirs' potential IHT liability.

Having a diversified portfolio that is tailored to meet your long-term goals and objectives is important, rather than short term returns. The effect of the coronavirus pandemic on markets has caused you to look at your investments on a daily basis. This suggests that you should be taking less risk. 

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

I’m surprised that you think your allocation to cash is high. Uncertainty about the course of the pandemic on top of ordinary high equity risk justifies a big weighting to this asset. Around a third of my portfolio is in cash.

You also have an upcoming income tax bill and hold many illiquid assets in the form of your properties. This warrants high liquidity elsewhere in your portfolio, especially as your properties expose you to unforeseeable liabilities. Given your high allocation to illiquid assets and risk aversion, do have enough cash?

This asset does not make much of a return. But as we’ve learned this year there are worse outcomes than a zero return. And you face the risk that you might be a forced seller at a time when asset prices are low. To avoid this, hold plenty of cash.

Also consider diversifying your investments a bit more internationally.