A MONEYWEEK SPECIAL INVESTMENT REPORT

MoneyWeek
How to escape the
most hated tax in
Britain

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Contents
Editors Letter .......................................................................................................................... 3
What exactly is inheritance tax? ............................................................................................ 4
How to legally and ethically avoid inheritance tax ............................................................... 8
A warning on political risk .................................................................................................... 11

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Editors Letter
Inheritance tax (IHT), is an emotive topic.
No one likes the idea of having to pay tax on money that theyve most likely
already paid tax on in the first place, and no one likes the idea of their
relatives being chased for money when they die.
So you can see why IHT was such a big campaign issue during the
election campaign last year. And you can also see why its one of the first things that
chancellorGeorge Osborne decided to change at his post-election emergency Budget.
As they promised prior to the election, the Conservative party effectively raised the point
at which IHT is payable (assuming you are a married couple, and own a homeworth at
least 350,000) to 1m.
This will be introduced in stages. From 2017, the allowance per person is 100,000. It then
rises gradually until it reaches 175,000 per person by 2020/21 which is when it reaches
the magic effective 1m mark.
Its a canny move. In 2010, only 2.6% of estates paid IHT. But in 2014, 6% of estates were
liable for it, due to the rapid recovery in house prices since the great crash of 2008. And
according to the Office for Budget Responsibility, nearly 12% of estates could be due to
pay IHT by 2019. Already, owning the average house in the South East (roughly 340,000)
or London (just over half a million) would leave a single person liable to IHT upon death
at current rates.
The British obsession with property being what it is, the Tories know that we instinctively
dislike the idea of our inheritors being forced to possibly sell a muchloved family home
simply to pay a tax bill. Perhaps you fall into the IHT net already. Or maybe you just
expect to do so one day. The point is that while IHT might affect only a minority of voters
today, it looms large in the minds of many more.
Yet the good news is that some radical earlier changes of Osbornes have already made it
easier to plan for IHT if youre likely to breach the existing limits.
Weve looked at these changes in detail in this report including how you could protect at
least 2 million from the taxman we hope you find it useful. If you have any questions,
please email me direct at john.stepek@moneyweek.com. We cant promise to answer
every individual email but I do read them all and well address any recurring questions
in MoneyWeek magazine.
John Stepek
Editor, MoneyWeek

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What exactly is inheritance tax?

In this report, we want to talk about how you can avoid paying what may be the most
hated tax in Britain inheritance tax. But before we get to that, we should talk about
exactly what inheritance tax is, and why its so unpopular.
Inheritance tax (IHT) is a tax thats payable on your estate when you die. Your estate is
made up of your net wealth at the point of death. So thats your house, your money, your
investment portfolio anything you might want to pass on to your inheritors, basically.
Certain assets are excluded but the majority are considered part of your estate for IHT
purposes.
Now, each individual has an IHT allowance of 325,000. That means your net wealth has
to amount to at least this much before youre charged IHT. But as soon as your estate
breaches this level, theres tax payable on the excess. And its not a small tax either its
40%. In short, nearly half of anything you own over the value of 325,000 when you die is
up for snaffling by the taxman.
Lets look at a quick example. Mr Jones, an unmarried man, dies at the age of 72. He
leaves behind a bungalow without a mortgage worth 250,000. He leaves behind a
portfolio of investments, held within an individual savings account (Isa), which is worth
125,000. And he leaves behind cash savings to the amount of 30,000.
Thats a total of 405,000. The IHT threshold is 325,000. So his estate owes 40% of the
excess of 80,000 to the tax office. Thats 32,000. (You can see the sums below).

Property
Investments
Cash savings
Estate value
IHT threshold
Amount liable for IHT
IHT payable at 40%

Mr Jones
250,000
125,000
30,000
405,000
325,000
80,000
32,000

Now, its worth understanding that if you are married (or in a civil partnership), your IHT
allowance is effectively doubled, as long as you make sure that you leave all of your assets to
your partner in your will. Between you, you can pass on 650,000 of assets. This was a very
sensible change introduced in 2007. Prior to that, you had to arrange your affairs very carefully
will-wise to make sure that your spouse wasnt lumbered with an unnecessary IHT bill upon
your death.
Lets look at Mr and Mrs Smith. They own a mortgage-free family home worth 600,000 and
between them have investments held within Isas worth 200,000, and cash of 50,000.

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Property
Investments
Cash savings
Estate value
IHT threshold
Amount liable for IHT
IHT payable at 40%

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Mrs Smith
650,000
175,000
10,000
835,000
650,000
185,000
74,000

Sadly, Mr Smith passes away. Mrs Smith inherits her late husbands IHT allowance. As a
result, when she passes away, between them they can pass on 650,000 in total IHT-free.
Of course, her estate is worth significantly more than this, so her estate has to pay out
74,000 to the tax office in this case.
Its worth noting that the Conservative party will add 100,000 to each spouse or civil
partners IHT allowance in the form of a family home allowance from April 2017,
rising to 175,000 by April 2021. For many people, that would effectively mean the IHT
threshold would be 1m so you could pass on a 350,000 house plus 650,000 in cash
say. So you should now remember to take this into account when looking at your assets.
The IHT bill is usually paid by the executor of your estate, (the person or people named
in the will to deal with the estate) using funds from the estate. This bill usually has to be
paid within six months of your death, or HMRC starts charging interest. So not only is this
a potential administrative headache, its also a major piece of paperwork that has to be
dealt with at a time when its probably the last thing your relatives want to be thinking
about.
Also, as the examples above show, raising the funds to pay the bill isnt always
straightforward. In the case of Mr Jones, the majority of his IHT bill could be paid
from his cash savings. But in the case of Mrs Smith, the majority of her estate is tied up
investments and property, with a relatively small proportion in cash savings. Turning the
investments into cash may or may not be straightforward. And in some cases, inheritors
have to sell the family home to raise money to pay IHT bills. As most people know, being
a forced seller of any even moderately illiquid asset is not an ideal position to be in if you
want to realise the full value of an asset.
Now, 650,000 is a significant amount of money. And its fair to say that IHT is something
that most people in the UK never have to pay. And now that the Tories have been true
to their word on the family home (regardless of how sensible it is to encourage Britains
fondness for property even further), then many more people will be taken out of the net.
However, given that house prices just keep on rising, the danger of breaching even an
increased IHT threshold particularly in the southeast is rising all the time, even for
those who would argue that they own relatively modest properties. Put it this way, you
dont have to be in mansion tax territory before you need to consider your potential IHT
liability.
Now, depending on your political viewpoint, you might argue that theres nothing wrong
with the concept behind IHT. Were hardly rabid socialists at MoneyWeek. But weve

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certainly argued in the past that Britain could encourage more productive investment
and prevent our boom/bust housing market from regularly wreaking havoc on the
financial system by finding a more sensible way to tax unearned wealth arising from
property price inflation capital gains tax on primary residences would be one option,
although something far more radical like a land value tax would be even better.
However, equally regardless of your political view, its hard not to agree that the core
problem with IHT is that to a great extent its very easy to avoid if you have the
resources to do so. The very wealthiest people can ensure they own assets, such as
agricultural land, that can be passed on without incurring IHT. They can also afford to
pay for expensive advisors to organise their affairs in such a way as to minimise their
exposure. And they can gift away far more of their wealth (another useful IHT planning
strategy) without having an impact on their day-to-day existence. In short, if youre
wealthy and well-organised, you can make sure that the taxmans final bite of your
wealth is as small as possible.
The people who are likely to be hit hardest (in relative terms) are those who are
moderately well-off, but not sufficiently wealthy to take advantage of advanced IHT
planning. People in this bracket may be unable to give away large sums without
impacting their own quality of life. They probably dont even think of themselves as
being especially wealthy, and in fact, within their own peer group, they probably arent.
Or their wealth may have rather crept up on them, so that by the time they realise
IHT might be a problem, its too late to make a long-term plan. Its this fact that IHT is
effectively optional for those who are wealthy enough and canny enough to avoid it that
strikes us as the most unfair aspect of the tax.
So its very good news that, thanks to some recent changes in an apparently unrelated
area of the tax system, there is now a very simple, entirely legal, and easily reversed
method of protecting your assets from inheritance tax.
Its called a pension.

How George Osborne turned pensions into one of the best

ways to avoid IHT
Thats right you dont need anything more complicated than a simple pension to shield
your assets from the taxman when you die. And its all thanks to changes that kicked in
on April 6th last year pensions freedom day.
Pensions have always been free of IHT in most cases, because they are held outside your
estate. However, despite that, any money youd saved into a pension was potentially
liable for a chunky tax charge if you died before you got the chance to spend it. If you
died before age 75 and you hadnt touched it, then that was fine (well, apart from the fact
that you had perhaps died somewhat prematurely) you could pass it on.

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But if youd accessed the pension, or died at the age of 75 or over, then a 55% tax charge
would be payable on any pension passed on (this is meant to reflect the fact that you got
tax relief when you first contributed to the pension). In short, any money put in a pension
was there to be spent by you and if you died before you got the full benefit of it, then
that was just tough luck.
Thats not the case anymore. Because this 55% death tax has now been abolished. So if
you die before you are 75, your heirs can now get the money as an entirely tax-free lump
sum, regardless of whether you have started drawing an income from it or not.
If you die after the age of 75, things arent quite as amazing. If your heirs take the money
as a lump sum or as income, it will be charged at their marginal rate. But if they simply
leave the money in the pension, it will continue to roll up tax free. So your beneficiaries
are not paying any more tax on the pension than theyd have had to if theyd saved that
money into a pension themselves.
So just to make this clear lets say you die at the age of 73, with 750,000 still in your
pension pot. Your beneficiary can both inherit that entirely tax free, and take an entirely
tax-free income from it. If you die a couple of years later with the same pot, at age 75,
your beneficiary still gets the 750,000 pot. The difference is that when they access it,
theyll have to pay tax on it at their marginal income tax rate but thats no different to
what theyd have to pay to access their own pension pot.
In short, a pension is now perhaps the premier financial vehicle for passing on wealth to
the next generation.

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How to legally and ethically avoid

inheritance tax
So how do you go about taking advantage of these changes? The good news is that it isnt
particularly complicated. However, it might involve changing the way that you think
about your pension.
When saving for retirement, most of us have grown used to seeing our pension as a longterm savings pot, designed primarily to provide an income in place of a salary when we
stop working. Theres a good reason that we think like that up until these new changes
came in, that was very much the main function of a pension.
But if you are wealthy enough to be thinking about passing a significant chunk of
yourmoney on to the next generation, then the new rules mean all of that changes. In
effect, a pension is no longer a way to save money for your own retirement. Instead a
pension is one of the most effective ways to package up your wealth for passing on. And
the logical follow-on from that is that you need to make sure you can generate income
for your retirement from other sources, so that ideally you can leave as much of your
pension intact as possible.
Below we look at some of the practicalities involved in using the new rules to your
advantage.

1. Put your money into a pension

These rules affect people putting money into defined contribution pensions. If you have
a defined benefit (or final salary) pension, the pensions freedom day rules dont affect
you. However, the benefits associated with defined benefit pensions are so great that
there are few circumstances in which you would want to trade them in for a defined
contribution alternative (we look at this in a bit more detail further on in this report).
You can contribute up to 40,000 a year, as long as you earn at least that much, into a
pension (although if you are a 45% income taxpayer, that will be reduced from April).
You may be able to contribute more than this if you havent used allowances from past
years. You can carry forward allowances from up to three previous years. So in practice,
in the 2015/16 tax year, you could put up to 180,000 into a pension, assuming you had
paid nothing in the previous three tax years, and that your earnings were at least that
level. (The allowance for the 12/13 and 13/14 tax years was 50,000, and it fell to 40,000
for 14/15, giving a total potential allowance of 180,000).
For more details on pensions and the new pensions freedom rules, you should read our
full report on pensions freedom day. But the material in this report tells you what you
need to know with regard to the IHT implications.

2. Beware the Lifetime allowance

Theres one catch with pensions and it can be quite a tricky one. Its the Lifetime
Allowance (LTA). This is a cap on the total amount you can have in pensions and still

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enjoy the tax advantages. At the moment, the LTA is 1.25m, but from April 6 2016 it
falls to 1m and if you breach this, then the excess in your pot is subject to a penal tax
rate of 55%, if you take it as a lump sum, or 25% on top of your marginal rate if you take
it as income. Also note carefully its a cap on the amount in the pot, not a cap on your
pension contributions. In other words, you could make the same contributions as your
neighbour, but if your pot grows faster than his, then you would be at greater risk of
hitting the LTA.
1m might sound a lot of money but in the context of a pension pot that you save up over
a lifetime, its not necessarily the case. For example, say you were 35, and had 350,000
in your pension pot. You plan to contribute 500 a month so 6,000 a year, well below
the annual allowance - for the next 20 years. Thats a decent pension for someone in their
mid-30s but it hardly sounds like millionaire territory. Yet if your pot grows by just 5% a
year, youll end up having 1.13m when you retire.
You might argue that the LTA will rise with inflation. But so far that hasnt been the case
in fact its fallen from 1.8m when it was introduced. There are various ways to lock in
an earlier LTA limit, but this typically involves promising not to pay any more money into
your pension so you have to be pretty confident that youre going to reach or breach the
limit through investment growth alone.
So this is something to be aware of.

3. But thats still at least 2m you can shelter

However, having said that, 1m is unquestionably a decent sum to be able to shelter from
IHT for your heirs. And if your partner earns enough to fill a pension too, then youre
looking at 2m between you.
Theres another interesting point to note too. The LTA comes into play every time theres
what the tax office calls a Benefit Crystallisation Event (BCE). In other words, when a
BCE happens, your pension pot is assessed against the LTA, and you might get a tax bill if
it has gone over it.
BCEs include taking money out of the pension, or dying before age 75, or turning 75.
But dying after 75 isnt a BCE. So you could keep your pension pot to just under 1m by
regularly withdrawing money if necessary, until you turn 75. You cant put any more
money into it after that point, but even if it achieves a grow rate of around 5% a year,
then by the time you were 88, the pot would be worth 1.9m. And when you die, the
whole of that could be left IHT-free to the beneficiary of your choice.
In short, you can leave a very significant sum of money to your heirs tax-free via a
pension. And if you are looking to shelter more than the sums were discussing here, then
you should probably already be talking to professional tax advisers about other estateplanning methods.

4. You need to live on something

Of course, the point of using the pension pot as a way to avoid IHT is that you need to

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keep the money in the pot. That means you need some other source of income to live on.
Perhaps you have investments in Individual Savings Accounts. Or part-time work. And
of course, theres always the state pension. But for many people, their main asset and
biggest headache when it comes to IHT is likely to be their property.
Now, weve always hated the popular clich my property is my pension. Its not
a sensible idea to rely on the property you live in as a savings vehicle to fund your
retirement. However, following the pensions freedom changes, then if you want to leave
a significant inheritance to your family, then assuming that you have a very valuable
home one that would breach the 1m threshold it might make sense to look at ways to
potentially release value from your home, rather than dipping into your pension.
So you could consider downsizing selling up and moving to a smaller home or a less
expensive area to extract the money from your home before you start drawing on your
pension. Another option to consider is equity release, where you borrow money against
the value of your home. It means you dont have to move, but do remember that this can
be an expensive way to raise money from your property so you need to do your research.

5. What if I have a defined benefit pension?

A defined-benefit pension means you know exactly what income youll get when you
retire (usually based on some sort of formula). Put simply, your employer takes all the
investment risk on your behalf, and you can look forward to a relatively stress-free
retirement, without any concern that youll run out of money before you run out of road,
as it were.
That sounds like a good deal, and it is which is why you rarely get these pensions
any more outside the public sector. If youre lucky enough to have a private-sector DB
scheme, its almost certainly worth hanging on to it. There are really very few reasons
why you might want to transfer out to a defined contribution (DC) scheme instead, to take
advantage of the new pensions freedoms.
If you are in poor health and dont expect to live long, it might be worth considering a
transfer to enable rapid access to your pot. And if you want to leave your pension pot
to your children it might be something to think about (DB pensions die with you, or
sometimes your spouse) but youd really need to be sure that your pot would actually
outlast your retirement, which suggests youd have to have significant alternative sources
of income.
Its also worth remembering that the new pensions freedoms can be changed or reversed
at will by this government or a future one. So you might swap the security of a DB
pension for the flexibility and inheritability of a DC pension and end up finding that
both those advantages get wiped out by a future regime. In short, the vast majority
of those with DB pensions should just thank their lucky stars. And if you do decide to
transfer for whatever reason, then make sure you get good advice before doing so.