While ISAs are a tax efficient way to build up wealth, they are far less efficient when passing them on.
Inheritable ISA rules were introduced in April 2015, meaning an individual can inherit the value of their deceased spouse or civil partner’s ISAs, providing they died on or after 3 December 2014.
Known as the additional permitted subscription allowance, it is based upon the value of ISA assets at the date of death and is in addition to the surviving spouse or civil partner’s own ISA allowance, preserving the tax efficiency of a couple’s ISA portfolio.
For example, if Mr and Mrs Smith both have £125,000 in their ISAs, on Mr Smith’s death, his widow will have an additional permitted subscription of £125,000 in addition to her own ISA allowance. This is available for three years from his death or 180 days after the estate has been administered.
Mrs Smith would still be entitled to it even if her late husband left his ISA portfolio to his children as it does not have to be the actual ISA monies that are subscribed.
If Mr Smith had multiple ISAs then Mrs Smith could combine all additional permitted subscriptions by transferring them to her provider of choice. However, once an ISA provider has been selected, the subscription can only be maximised with that chosen provider.
Inheritance tax rules
The inheritance tax (IHT) considerations of inherited ISAs are often overlooked or misunderstood by clients.
While there is no IHT on ISAs inherited between spouses or civil partners, this has nothing to do with inherited ISA rules; it is purely due to the IHT spousal exemption.
This doesn’t apply to unmarried couples (typically divorcees or widows/widowers in a relationship) or on the subsequent death of a surviving spouse or civil partner.
Continuing our example, on Mrs Smith’s death her ISAs of £250,000 (assuming no further subscriptions) are included in her estate for IHT purposes. Assuming any nil rate bands are already used, these potentially give rise to £100,000 in IHT.
For every additional annual ISA subscription Mrs Smith makes between her husband’s death and hers, HMRC would effectively get 40% (£8,000 in 2018/19) in delayed IHT.
Given that ISAs cannot be held in trust, what planning can be done to mitigate this? In the past, clients have cashed in their PEPs and ISAs in their mid to late 60s and reinvested them in an investment bond held in a discounted gift trust to provide an income for life and IHT efficiency.
The use of AIM shares inside an ISA attracts business property relief and is IHT-free after two years if held by the client on death, but this is often not appropriate to a client’s attitude to risk or capacity for loss.
Another alternative is to use a whole-of-life protection plan, written on a joint life second death basis in a discretionary trust.
With premiums perhaps paid from ISA income or withdrawals (which could be replaced within a flexible ISA) and falling within the annual IHT gift and/or normal expenditure out of income exemptions, the sum assured would be paid out on second death into the trust for the beneficiaries to cover the IHT liability.
Subject to health and the ability to continue to pay the premiums, this is a quick and simple solution that retains the tax efficiency afforded by ISAs.
Until earlier this year, there was a gap in the rules that meant that between the date of death and the formal closure of the estate (which could take months if not years) ISAs were subject to tax at the highest rates applicable to personal representatives.
However, from 6 April 2018 ISAs have retained their tax-advantaged status during an estate’s administration period (though no new monies can be paid in), saving the personal representatives having to cash in ISAs and account for tax.
This is good news for personal representatives and surviving spouses or civil partners as it means the additional permitted subscription will be based on the (hopefully) higher ISA value at the date of closure rather than at the date of death.
Andy Woollon is a wealth specialist at Zurich UK