IHT: your questions answered on trusts, spouses and tax traps

Inheritance tax (IHT) planning is about much more than gifting money during your lifetime. The way assets are owned, how they pass between spouses, and whether trusts are involved can all have a significant impact on the tax ultimately paid by an estate.

In this Q&A, we answer some common questions on transferable inheritance tax allowances, joint gifts, trusts and the residence nil-rate band. While some of the rules are highly technical, understanding the key principles can help you avoid costly mistakes and make more informed estate-planning decisions.

As always, inheritance tax planning should form part of a broader financial plan, and specialist advice may be appropriate where large sums or complex arrangements are involved.

For more on IHT gifting allowances read: IHT gifting allowances: 8 key questions answered

Transfers between spouses

Q. My wife passed away last year. I was informed that I would receive her IHT allowance on top of mine. Is that still the case after 20 odd years?

A. If you were married when your wife died, any unused IHT nil-rate band from her estate can generally be transferred to your estate when you die. This is often referred to as the “transferable nil-rate band”.

Importantly, it does not matter how long ago your wife died. HMRC confirms that the transferable nil-rate band can be claimed regardless of how long ago the first spouse died, provided the surviving spouse dies on or after 9 October 2007.

In many cases, where the first spouse left everything to the surviving spouse, none of his or her nil-rate band was used because transfers between spouses are normally exempt from IHT. As a result, up to 100% of the unused allowance may be available to transfer.

However, the amount available depends on what happened when your wife died. For example:

• If she left everything to you, it is likely that all her nil-rate band remained unused.
• If part of her estate passed to other beneficiaries, some of her nil-rate band may have been used, reducing the amount available to transfer.

The transfer is not automatic. When your estate is eventually administered, your executors would normally need to make a claim to HMRC and provide details of your wife's estate, including documents such as the death certificate, probate records and (if applicable) her will.

So, in principle, the fact that your wife died more than 20 years ago does not prevent her unused IHT allowance from being transferred to your estate.

• Read: 5 IHT mistakes that could cost you thousands

Q. Can you please explain the "grossing up" rule applying to IHT when money is left to say your wife whose bequest is free of IHT and your child (or any recipient) whose bequest is subject to IHT?

A. "Grossing up" is an Inheritance Tax (IHT) calculation that can arise where:

• part of an estate passes to an exempt beneficiary (such as a spouse or civil partner); and
• another beneficiary (such as a child) receives a legacy that is stated in the will to be received "free of tax".

In these circumstances, the child must receive the full amount specified in the will. The IHT attributable to that gift is therefore paid from the residue of the estate rather than deducted from the child's inheritance.

HMRC explains that where a chargeable beneficiary receives a gift free of tax and the residue is exempt, the gift must be "grossed up" to reflect not only the value of the gift itself but also the benefit of someone else paying the tax on it.

In simple terms, grossing up answers the question: "How large would the gift have needed to be before tax so that, after tax had been paid, the beneficiary still received the amount stated in the will?"

Let’s look at an example. John dies with an estate worth £600,000 and leaves:

• £375,000 to his daughter, free of tax
• the remainder of his estate to his widow

We assume John has his full £325,000 nil-rate band available and there are no other reliefs or exemptions affecting the calculation.

The daughter's legacy exceeds the nil-rate band by £50,000 (£375,000 − £325,000).

Because the daughter is to receive that amount free of tax, the £50,000 must be treated as the net amount remaining after IHT has been paid. To find the equivalent gross amount, HMRC's grossing up rules require the excess to be divided by 60% (or multiplied by 100/60).

£50,000 × 100 ÷ 60 = £83,333

The grossed-up value of the daughter's legacy is therefore: £325,000 + £83,333 = £408,333

The amount above the nil-rate band is treated as £83,333. IHT at 40% is therefore payable on this amount.

£83,333 x 0.4 = £33,333

The estate is therefore distributed as follows

The widow's inheritance remains exempt from IHT under the spouse exemption. However, the amount she receives is reduced because the estate has had to meet the tax arising on the daughter's tax-free legacy.

HMRC has a calculator which can help you to calculate the IHT due when grossing up is applicable: Inheritance Tax grossing up calculator - GOV.UK

While the tool is helpful, it does not replace getting professional advice - particularly as grossing up can interact with many other IHT rules and allowances.

Joint gifts

Q. I am much older than my wife. Our assets are owned jointly. If we buy houses for our children and I die within seven years, is the gift exempt if my wife lives, say, eight or more years after the gift?

A. Unfortunately, HMRC does not consider gifts to be made jointly. In cases where a gift is made by two people jointly and equally, then HMRC considers that half of the gift is from one of them and half the gift is from the other.

Therefore, if together you bought a house worth £200,000 for a child, then that would be considered a £100,000 gift from each of you. If you died within seven years of the property purchase, that £100,000 would be considered a failed gift and form part of your estate for IHT purposes - regardless of how long your wife lives.

• Watch: Inheritance tax - What people get wrong about the 7-year rule

If you have not used it already, you could apply your £3,000 annual exemption to this gift - reducing its value for IHT purposes from £100,000 to £97,000. Remember you can carry forward any unused annual exemption for one tax year, so could potentially reduce the value of your gift to £94,000 for IHT purposes provided you had not used any of last year’s allowance.

Q. I have read that HMRC normally consider gifts made from a joint account to be 50% from each account holder. My wife has negligible income, whereas I have significant pension income. I am making monthly gifts to my daughter as "normal gifts out of income". These are bank transfers from the joint current account. I am keeping records to confirm these regular gifts come from my unspent income. My question is: how do I ensure HMRC accept that these gifts are 100% from me?

A. You are correct that HMRC will generally consider a joint gift to be made by each of the partners individually (usually split 50/50 between them). The key thing with the “normal expenditure out of income” allowance is to be able to evidence what you are doing.

You are keeping records - which is very sensible - and that may help to demonstrate to HMRC that this truly is your income you are gifting, not your wife’s. However, if you are unsure, it would be well worth speaking to a specialist tax adviser.

• Read: How to keep IHT records and avoid an unnecessary bill

If you are very concerned, would it make sense to create a separate bank account for your surplus income in your name alone and make the gifts to your daughter from this account?

It is a small difference but it may help to convince HMRC that these gifts truly are from you alone.

Q. Should my wife and I keep IHT records separately as individuals or as a couple? We manage our finances by sharing income and expenditure, and our savings and investments are a mix of joint and individually owned. We give regularly to our grandchildren’s JISAs, which we can afford to do by combining our income but not if we are separately assessed.

A. This is a very good question. Given that HMRC considers gifts to be made individually rather than jointly, it would be sensible to keep two separate records for each of you. However, you should note down both your individual income and your combined income - recording that you pool both together.

• Need that next level of support? Fidelity’s financial advisers can help with savings, investments, retirement and pensions

Trusts

Q. What are the main kinds of trusts and how do they work from an IHT perspective?

A. Trusts can be a useful estate-planning tool, but their Inheritance Tax (IHT) treatment depends on the type of trust involved. Broadly speaking, the main types of trust are:

Bare trusts

With a bare trust, the beneficiary has an immediate and absolute right to the trust assets and any income they produce.

For IHT purposes, the assets are generally treated as belonging to the beneficiary. A gift into a bare trust is usually treated in the same way as a gift made directly to the beneficiary. If the settlor survives seven years, the gift will normally fall outside their estate.

Interest in possession trusts

These trusts give one beneficiary (often called the life tenant) the right to receive income from the trust during their lifetime, while the capital passes to other beneficiaries later.

The IHT treatment depends on when the trust was created and the type of interest involved. In many cases, the trust assets are treated as forming part of the life tenant's estate for IHT purposes.

A common example is a trust created in a will that allows a surviving spouse to receive income for life, with the capital passing to children on the spouse's death.

Discretionary trusts

Discretionary trusts give trustees flexibility to decide which beneficiaries receive benefits and when.

These trusts are generally subject to the "relevant property" regime. This means:

• a charge of up to 20% may apply when assets are transferred into the trust above the available nil-rate band;
• a ten-yearly charge may apply while assets remain in the trust; and
• an exit charge may apply when assets leave the trust.

Bereaved minor and age 18-to-25 trusts

These are special trusts for children who have lost a parent.

They benefit from favourable IHT treatment and are generally not subject to the full relevant property regime that applies to discretionary trusts.

Disabled person's trusts

Special rules apply where the trust is established for a disabled beneficiary.

These trusts can benefit from more favourable IHT treatment than ordinary discretionary trusts and are often used to provide long-term financial support without exposing the beneficiary's inheritance to the full relevant property regime.

What are the IHT implications?

The most important distinction is whether the trust falls within the relevant property regime.

Discretionary trusts are the most common example of a relevant property trust and may face entry, periodic and exit charges. By contrast, bare trusts and many interest in possession trusts are generally taxed by reference to the beneficiary rather than through the relevant property regime.

As a result, two trusts holding exactly the same assets can have very different IHT consequences depending on how they are structured.

• Read: 9 ways to protect your pension from IHT changes

Q. Where a will is set up to put the property into a lifetime trust, does this compromise the residence nil rate band as the beneficiary that is the direct descendant is no longer seen as the direct beneficiary?

A. The residence nil-rate band (RNRB) is generally available where the property is left to a direct descendant, such as a child or grandchild. However, the rules contain special provisions for certain types of trusts.

If a property passes into an immediate post-death interest (IPDI) trust for a surviving spouse or civil partner, the RNRB can still be available. When the surviving spouse later dies, the trust assets are generally treated as part of their estate for IHT purposes and the property can still qualify for the RNRB if it ultimately passes to direct descendants.

Similarly, HMRC's guidance confirms that property left to direct descendants through certain qualifying trusts, including some bereaved minor trusts, age 18-to-25 trusts and trusts for disabled beneficiaries, can still be treated as being "closely inherited" for RNRB purposes.

By contrast, if the property passes into a discretionary trust, the position is less favourable. A discretionary beneficiary does not have an automatic entitlement to either income or capital, and the property will not normally be regarded as being closely inherited by a direct descendant. As a result, the RNRB may not be available.

Therefore, the key issue is not simply whether the property passes into a trust, but what type of trust is used and what rights the beneficiaries have under it.

The exact outcome depends on the wording of the will and the type of trust created, so professional advice should be sought before assuming that a trust arrangement will preserve the RNRB.

There's a lot to think about when it comes to inheritance planning. And with so many options available, it can really help to talk to someone about your investments, particularly about your pensions. Our financial advisers can provide a personal recommendation for a one-off event or ongoing advice for more complex needs. Find out more about our advice service.

Got a burning question you want to ask? Why not drop us a line. Click here to ask your question.

• Read: IHT gifting allowances: 8 key questions answered
• Read: Who can I leave my pension to?
• Read: What is Power of Attorney? The basics

Important information: investors should note that the views expressed may no longer be current and may have already been acted upon. Tax treatment depends on individual circumstances and all tax rules may change in the future. Withdrawals from a pension product will not be possible until you reach age 55 (57 from 2028). This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.