Utilising your annual ISA allowance is one of the most tax-efficient and popular ways of investing. The result is that over the last 20 years many people have built up significant wealth within ISAs.
Over the last 10 years we have seen significant investment and property growth, whilst the nil rate band (the threshold over which inheritance tax is applied) has remained fixed at £325,000. This, combined with increased wealth held within ISAs, raises the question as to whether your ISA will be subject to inheritance tax (IHT) and if there is anything you can do about it.
The tax treatment of ISAs
The main features of ISAs are as follows:
- You can contribute up to £20,000 per year into ISAs, which can be held in cash, stocks and shares, or a combination of both.
- ISAs are not subject to any income tax or capital gains tax on any income generated or any gains produced by investments held within an ISA.
- You can withdraw money from your ISA without any tax liability or penalty.
- On death, your ISA can be passed to your spouse without losing its tax-advantaged status. This is achieved through the additional permitted subscription (APS) rules, which mean that your spouse is given an additional ISA allowance equivalent to the value of your fund at the date of death.
Unfortunately, you are unable to gift your ISA without losing the tax benefits and it is not possible to place ISAs into trust, meaning the benefits of ISAs do not normally extend to IHT planning. However, there is one other option that you could consider – business relief.
Business relief and ISAs
Business relief, formerly known as business property relief, was first introduced in 1976 to allow family businesses to be passed on to the next generation free on IHT. Rules have since been expanded to encourage investment into small or early-stage companies. These small or early stage companies are known as qualifying companies, and tend to be privately owned companies, partnership or sole trader businesses.
If you own shares in a qualifying company, you are able to avoid IHT providing that you have owned the asset for at least two years. This is done through business relief.
Since 2013 you have been able to invest in these qualifying companies and buy shares listed on the alternative investment market (AIM).
This means that if the company qualifies and you hold the shares for at least two years, your estate can potentially benefit from a 100% IHT exemption on your ISA fund. There is also the added benefit that unlike a gift or a trust investment, AIM ISA investments do not use up any of your nil rate band. This means that you are free to undertake other forms of IHT planning at the same time if needed.
A short guide to AIM investing
The alternative investment market allows companies which do not yet qualify for the main exchanges to trade their shares and raise capital to grow their businesses. Some of the well-known companies listed on AIM include:
- ASOS
- Fevertree Drinks
- Hotel Chocolat
- Jet 2
- Joules
- Majestic Wine
You are able to buy AIM shares on a suitable trading platform with the possibility of holding these investments either in an ISA or a general investment account. Whilst it is sometimes possible to hold these shares within a pension, this may not be a worthwhile option as pensions are already exempt for IHT. It is also important to note that many investment managers run AIM portfolios, meaning that they are responsible for the selection of the underlying companies allowing you to benefit from their expertise and due diligence. This is one option to consider in managing the risk associated with AIM investments, as well as ensuring that there is sufficient diversification within your AIM holdings.
The downside of AIM investments is the potential risk that comes with investment into AIM shares. Companies listed on the AIM exchange tend to be smaller and may not have the stability of larger companies listed on the main indexes worldwide. Therefore, there is likely to be a high level of volatility and some of the companies may fail.
There is also liquidity risk to consider. AIM shares may be more difficult to sell as there will be a smaller pool of willing buyers.
Due to the risks associated with AIM investment, it is worth considering diversifying your holdings across multiple companies to help smooth out some of the risk.
Other options for reducing your IHT bill
If you are not wanting to take the risks associated with AIM investments or you are looking for alternative ways to reduce your IHT liability, it is important to consider that there are a number of other solutions that may better suit you, for example:
- Making use of your small gift allowance each year. The first £3,000 gifted in any given year or any gifts made out of surplus income will fall immediately outside of your estate.
- As well as making small gifts, it would be worthwhile considering making larger outright gifts. These will fall outside of your estate after seven years.
- Placing money in trust. Generally, these gifts will also fall out of your estate after seven years, however depending on the size of the gift and the type of trust, there may also be entry charges, periodic charges and exit charges.
- Topping up your pension. Pensions can be passed on free of tax on death before age 75. After age 75, the beneficiary simply pays income tax on any withdrawals at their own marginal rate.
- Opting for other investments that qualify for business relief such as shares in a private business or an enterprise investment scheme (EIS).
- Making charitable donations.
It is important to balance tax advantages with other planning considerations. Ultimately, your financial plan should be driven by your goals and not simply the requirement to save tax.
Please do not hesitate to contact a member of the team if you would like to find out more about inheritance tax planning.