Darling incentivises the wrong investors

Margaret Coles is a fit and healthy 73 year old widow.  Her late husband used his Inheritance Tax Nil Rate Band by leaving a holiday property to his children. She remains fairly well off with a house, various investments including an ISA portfolio, a healthy sum on deposit and two pensions.  Her son, Raymond, helps his mother to manage her financial affairs and has suggested she take immediate advantage of the new ISA limit for older persons announced in Alastair Darling’s recent Budget. He thinks there will be a stockmarket recovery within the next few months and believes she should capture the maximum benefit by adding to her substantial ISA portfolio by investing her 2009/10 ISA allowance now.

The primary benefit of placing investments within an ISA ‘wrapper’ is that they are then permanently exempt from Capital Gains Tax (CGT) and from higher rate Income Tax. But how beneficial are these concessions in general and, in particular, to Mrs Coles? Anecdotal evidence from advisors indicate that a high proportion of ISA holders could easily hold and manage their investments perfectly well and effectively tax-free by utilising their existing annual CGT allowances. Most ISA investors, such as Mrs Coles, are not higher rate Income Tax payers and so will not suffer any further tax on dividends/distributions. So, are they needlessly investing in ISAs?

The only real beneficiaries of these tax-exempt investments are either:

•  (a)those taxpayers who invest in cash or fixed interest investments (not equities or mixed funds) and who benefit from exemption from standard rate Income Tax on those specific investments, or
•  (b)higher rate taxpayers who are already utilising their annual CGT allowances.

For these two groups the continuing concessions are very good news. In particular young, dynamic, higher-rate taxpayers saving on a monthly basis into high growth funds for school fees and other medium term commitments, and doing so with the added benefit of pound cost averaging, are likely to benefit most. Whilst Mrs Coles is interested in boosting her flagging income, which has fallen with interest rates over the last year or so, she is certainly not in the second group. Even in her search for income the benefits of Income Tax relief on currently miniscule yields are not great.

In reality the Treasury is actually misleading naïve investors into thinking there are substantial tax benefits in retaining ISA portfolios into one’s dotage, while simply ensuring that it can continue to collect large amounts of IHT from the unwitting and unprepared elderly investor. Arguably investors from their mid-sixties onwards who believe they will have an IHT liability should no longer be holding ISAs and certainly should not be buying more. What so many of them do not realise is that they will suffer a punitive IHT sting at death, whereby at the top end they and their families potentially lose a colossal 40% of their hard-earned savings. This loss completely dwarfs the often marginal annual tax benefits resulting from the ISA wrapper.

So what can Mrs Coles do to avoid IHT on her accumulated savings? The answer is simple, she should encash her ‘tax-free’ ISA and supplement the proceeds to a total of £325,000 by selling a portion of her stockmarket investments and then make a gift of the total sum to her chosen beneficiaries via a flexible reversionary trust. Although gifts into such trusts constitute an IHT taxable transfer there will be no tax so long as the gift is within the current Nil Rate Band for IHT – £325,000 per person.

Such gifts then fall out of account after 7 years and so there is an opportunity for each taxpayer to make gifts up to this level every 7 years. Mrs Coles has a life expectancy of some 13+ years and so should easily survive the first 7 year inter vivos period and might even survive a second. Even should she not survive to see her gift fall out of account, any growth (recovery) enjoyed by the gifted assets will occur outside her chargeable estate.

A good flexible IHT gift trust will offer Mrs Cole’s trustees extraordinary ongoing flexibility over the trust whereby she can be supported with regular or occasional ‘reversions’ to top up her conventional income. In her case she will certainly need to replace income from her surrendered ISAs (Capital Gains Tax exempt) and part of her share portfolio (which she was able to dispose of within her annual CGT allowance and without incurring Capital Gains Tax).  Since the assets will have been placed within a gift trust then it is proper that drawings or reversions from the trust should be made available to replace that sacrificed income. The trust wording is sufficiently flexible to also allow the trustees to continue to look after the needs of her children and grandchildren in exactly the same kind of way as before the gift.

Assuming she does live those 7 years then she will have dramatically reduced the potential IHT liability on her death.   Moreover her ‘income’ is maintained and, via her trustees, she retains tremendous flexibility over the future return of funds from the flexible trust.  The table shows that at current levels her family is likely to benefit from a tax saving of some £130,000 which completely dwarfs any conventional’ benefit she is likely to receive from her ISAs.

Darling incentivises the wrong investors

Paul Wilcox
Chairman & Technical Director, WAY Group.

Posted on 24th April, 2009 | Tags: Budget 2009, IHT, IHT Mitigation, Inheritance Tax Nil Rate Band, ISAs |
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