Financial planning in the twilight zone

Sci-fi fans might remember the oft-repeated ’60s TV series, The twilight zone. Each episode—often a futuristic morality tale—opened with a narrator’s monologue in which the Twilight Zone was described as “a land of both shadow and substance.”

In financial planning, there is also a twilight zone. More down-to-earth than the fictional version, it’s the point between someone who dies and their estate being distributed. This is a delicate time for many families, who may be deeply grieving. But, for those willing to focus on the tax practicalities, it offers opportunities to save thousands of pounds in tax.

A very basic introduction to the world of probate can be helpful. When you die, the executors of your estate apply for probate — the legal right to distribute your assets. In Scotland this is called ‘confirmation’ but the process is similar to that in England and Wales and the tax benefits described below apply.

One of the most important things they need to do is assess your estate to determine if inheritance tax (IHT) is owed and if there are any outstanding debts to settle. It is usually a good idea to process both before distributing money to beneficiaries.

Your estate is assessed for tax purposes on the date of your death. It can take a year or more to distribute the assets – our twilight zone period. So what do you need to know?

Deed of variation

An amending deed allows beneficiaries, with the agreement of executors, to retroactively alter the terms of a will so that some or all of their share goes elsewhere.

If Grandma left all her money at a cat’s house, it won’t allow you to redirect it to your pockets. But for some recipients, a large inheritance is more of a burden than a blessing. They may already have enough for their own needs and will only pass the money on to the next generation when they die. The biggest beneficiary in this scenario could be HM Revenue & Customs.

Let’s say Granny leaves you £1m, subject to 40% IHT. You inherit £600,000. If you, in turn, leave this to your children when you die and the IHT is charged again, they will only receive £360,000 – 64% will be gone in tax. A deed of alteration allows you to renounce your inheritance by changing the terms of the will so that the money goes directly to your children. You are effectively skipping a generation for the tax.

You may not be sure whether you might need the inheritance yourself – to cover aftercare costs, for example. You can use a deed of amendment to direct the money to a discretionary trust. This way, the trustees can tap into it for your benefit if necessary or make distributions to other beneficiaries. This money will not count in your estate for IHT purposes when you die.

You can also use a deed of amendment to redirect money to charity. I have a client whose father recently passed away. He had left £100,000 – 5% of his net estate – to a group of charities.

She used an amending deed to double all donations, bringing the gift to £200,000. You might think it would have cost her £100,000, but she was actually £12,000 better off.

When you donate 10% of your net worth to one or more registered charities, the IHT rate is reduced from 40% to 36%. So:

  • The net estate was £2 million; the original charitable donation was £100,000, leaving my client £1.9 million. After IHT, he would be left with £1.140m.

  • By donating £200,000, my client was left with £1.8 million. After IHT at the reduced rate, he was left with £1.152 million.

People often like to leave a set amount to charity. If the value of your estate increases between the execution of your will and your death, the intended gift may be below the 10% threshold that triggers a reduction in the IHT. If you leave between 4% and 10% of your net worth to charity, your beneficiaries will be better off if you donate the full 10%. An act of amendment may allow beneficiaries to benefit from this IHT charitable reduction.

A deed of amendment can also help you reduce capital gains tax (CGT). Maybe you inherited a vacation home. You know you will resell it at some point, but first you and your family would like to enjoy it for a few years. When you dispose of it, you will be liable for CGT on any increase in its value since the death of the original owner.

You can deduct your annual CGT allowance from this gain. With a deed of alteration, you could ensure that you are not the only beneficiary – you could split the house between you and your children. That way, when you come to sell it, you can also have their CGT allowances to offset the gains.

Although you have two years to draft an amending deed, it is generally a good idea to make the necessary decisions before the money is distributed, which can take more than two years. Discuss these issues as soon as possible with your advisor, estates lawyer and executors.

Capital gains

Upon your death, all capital gains accrued up to the time of death are “cancelled”. The slate is cleaned. Helpful, HMRC then grants your ghostly self – your estate – a new CGT allowance.

Assets can increase in value between death and the completion of estate administration, which could lead to a CGT issue if you wish to liquidate them. Executors may dispose of some of these to use the estate’s CGT allowance – £12,300 in the tax year of death and the following two tax years.

Exploitation of losses

More recently, the stock market correction has meant that the challenge has been losses rather than gains. A client of mine recently inherited a stock portfolio from his mother. Between his death and his distribution, their value fell by £50,000. The shares were not suitable for my client, and he asked the executors to sell them to free up money to buy something more in line with his needs and risk attitude.

On disposal of the assets, the executors returned to HMRC and requested that the IHT be recalculated, based on the lower sale value. They received a £20,000 rebate.

In calculating the lower value, you must consider the cumulative amount of assets that the executor sells within 12 months of death. So, with IHT rates being higher than CGT rates, you may need to be quite forensic – only ask the executor to sell the shares that have fallen in value to create a cumulative loss, then ask for a handed over to HMRC.

The rules are complex, and that’s the territory of a good probate lawyer, who should know everything I’ve covered and more. But, as for the original blurred area, there is a moral to this tale. Do not rely solely on your lawyer to raise these points. I always encourage my clients to be proactive in these cases. Negotiating this delicate ground can often save them thousands of pounds.

Charles Calkin is a financial planner at wealth manager James Hambro & Partners

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