Dr. Benson’s Casebook

“I thought ISAs were tax free?”

This is the first in a series of blogs from “Dr. Benson’s Casebook” .
Our Technical Manager, Mark Benson, delves into his IHT surgery files for topical cases and selects those likely to be of most interest to IFAs (and their clients)..

In each case he gives his opinion and demonstrates the methods he would use to solve the issues raised.

Case Study:

Graham is 70 and a divorcee.  He has two adult daughters from his former marriage who will eventually inherit his wealth.  His assets are as follows:

Assests:
House (mortgage free): £300,000
Bank accounts: £15,000
Cash ISAs: £20,000
Stocks & Shares ISAs: £70,000
Value as at May 2011: £405,000

He has met with his IFA who suggests that he should undertake some planning to reduce his potential Inheritance Tax (IHT) bill of £32,000.  Graham is perplexed, since he is aware that he can leave £325,000 in his will free of IHT and thought that his taxable estate would fall within that nil rate band?

He consults Dr. Benson at his IHT surgery, who says:  Graham’s IFA is quite correct in his assessment of the potential IHT liability.  It turns out that Graham held the common misperception that his ISA investments really were tax free, and so did not count them when calculating his estate.  Graham can be easily excused this confusion. For example, a visit to a well known consumer money website garners the following explain of an ISA:   “it’s simply a tax free wrapper into which you can place either cash or shares.”

Unfortunately the site in question, along with many others who also ought to know better, has incorrectly suggested that ISAs are completely tax free and overlooked the fact that the tax advantages only extend to Income Tax (partially) and Capital Gains Tax (CGT), but not to IHT. Graham’s IFA has therefore correctly calculated the potential IHT liability.

The good news for Graham is that I can reassure him that he has been well advised to make use of his ISA allowances up to this point. The savings in Income Tax on his Cash ISAs and CGT on his Stocks and Shares ISAs over the years are real and valuable. However the situation now is that, as he enters the later stage of his life, the future savings in these two taxes are likely to be less valuable than the potential savings if the IHT issues were to be addressed. Let’s see why:

If Graham were to transfer most of his ISA funds into a flexible reversionary interest trust he could remove the current IHT liability once the transfer falls out of account after 7 years, whilst retaining the potential to benefit from the capital if needed in the future. This would mean forgoing the Income Tax and CGT benefits of the ISA wrappers. Could the lost benefits amount to more than the potential IHT saving of £32,000?

Let’s first consider his cash ISAs. The potential IHT on the £20,000 balance is £8,000. Graham has kept a careful eye on the rates on offer and has transferred his holding into the current “best buy” account paying 3.35% p.a. (source Moneyfacts.co.uk). As a basic rate taxpayer he therefore saves £134 p.a. in Income Tax on the interest received. That sounds great, until I point out that it will take him almost 60 years to save enough Income Tax to offset the IHT bill!

How about the Stocks and Shares ISAs? Suppose that Graham lives another 10 years to age 80 and that he enjoys an average capital growth of 5% p.a. over that time. His holdings would grow to just over £114,000 which would attract an IHT charge of around £45,000 (ignoring growth in the nil rate band) if held in his estate at death. If the assets had been transferred into the trust, and the trustees passed on the units to his daughters after his death, their CGT bill would be less than £13,000 (at the very worst, but probably much less with some simple tax planning) – below 1/3 of the potential IHT liability.

In conclusion, although Graham’s ISAs have been a valuable and sensible choice over previous years, now may be the time to think about saving IHT as a priority over Income Tax and CGT.

Mark Benson, TEP CertPFS,
Technical Manager, WAY Investment Services Limited
13th June 2011
www.waygroup.co.uk

Posted on 13th June, 2011 | Tags: Dr Benson's Casebook |
Comments: Have Your Say

Is it a fair cop?

On the face of it the recent statement that ISAs are here to stay is good news for investors.  It means that savers can continue to put aside £7,000 each year into investments which are permanently exempt from Capital Gains Tax (CGT) and from higher rate Income Tax.  But how beneficial are these concessions?  Anecdotal evidence from some of WAY’s supporting IFAs indicate that a high proportion of PEP and ISA holders could easily hold and manage their investments perfectly well and effectively tax-free by utilising their existing annual CGT allowances.  Most are not higher rate Income Tax payers and so will not suffer any further tax on dividends/distributions.  So are they needlessly investing in PEPs and 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 minority groups the continuing concessions are very good news.  WAY has many regular contribution ISA investors who are young, dynamic, higher-rate taxpayers saving into high growth funds for school fees and other medium term commitments, and doing so with the added benefit of pound cost averaging.

So far, so good.  What is rarely questioned, however, is whether these ISA savers should be taking any other considerations into account.  Is the ISA news all good or is there a potential downside?

By stealth tactics the Treasury is misleading investors into thinking there are substantial tax benefits in retaining PEP and 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.  In my view investors from their mid-sixties onwards who believe they will have an IHT liability should no longer be holding PEPs and ISAs.  What so many of them do not realise is that they will suffer a punitive IHT sting at death, whereby 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.

Based on Office of National Statistics figures for holders of ISAs and PEPs, combined with our own research, WAY Group estimates that at least 165,000 elderly investors (aged 70 or older) are holding ‘tax-sheltered’ portfolios in excess of £100,000.  Based on published mortality rates this would mean that some £0.5bn, or one sixth of the annual total IHT tax take of £3bn, arises from IHT on PEPs and ISAs from this group!  This cannot be right.

I believe that there are substantially more then 300,000 investors across the country who currently hold substantial equities-based tax-free investments within their portfolios with no provision whatsoever for these funds to be transferred into alternative investment schemes which can mitigate the IHT. Over half of these investors – some 165,000 – of those with large tax-sheltered investments are aged 70 plus. This is the age group at the greatest risk of losing out on the tax-free benefits of their savings strategy.

So what can these investors do to avoid IHT on their accumulated savings?  The answer is simple, even after Gordon Brown’s Budget measures from last year.  They should encash up to £285,000 of their ‘tax-free’ savings and gift them to their chosen beneficiaries via a flexible trust.  Although gifts into such trusts now constitute an IHT taxable transfer there will be no tax so long as the gift is within the current Nil Rate Band for IHT – £285,000 per person.  Such gifts 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.

At age 65 the average investor still has a life expectation of some 16 years (males) to 19 years (females).  Even at age 75 these numbers are 9+ and 11+ years.  This means that any average investor has time to gift their former PEPs and ISAs completely IHT tax-free so long as they start shortly after their mid 60′s.  The real benefit of the tax exemptions associated with PEP/ISA portfolios is that when this IHT mitigation exercise becomes appropriate the targeted funds can be surrendered entirely tax-free at that point, making investment in an IHT mitigation plan that much more effective.

WAY offers a comprehensive range of IHT mitigation arrangements, uniquely offering both unit trust based and offshore bond based plans.  These are further subdivided between flexible and discounted schemes whereby trustees have a great deal of flexibility in making financial provision for both donors and beneficiaries.

A simple recent example illustrates the benefit of this approach.  The lady in question was a fit and healthy 73 year old widow.  She and her late husband had bought their ex-Council house under the ‘right-to-buy’ scheme and the rump of the mortgage was paid off from her husband’s PEPs and ISAs.  The table shows her circumstances both before and after swapping her PEPs and ISAs for a combination of flexible and discounted schemes from the WAY stable.  She has a life expectation of some 13 years but only needs to survive 7 to remove the gift into trust from her estate.  Assuming she does live those 7 years then she will have virtually removed IHT from her estate.  Even were she to live less than 7 years then her net IHT liability would be substantially reduced as a result of moving her funds.  Moreover her income is maintained and, via her trustees, she retains tremendous flexibility over the future return of funds from the flexible trust.

Before vs After Planning

Paul Wilxox,
Chairman & Technical Director, WAY Group.

Posted on 19th June, 2009 | Tags: Capital Gains Tax, Higher Rate Income Tax, IHT, ISA, ISA Savers, Life Expectation, PEPs |
Comments: One Comment