Passing on wealth: Is the next generation the right recipient?
Andy Woollon 05 August 2019
It appears IHT is here to stay (and may indeed worsen), so what can advisers do now to help parents pass on wealth?
In early July the Office of Tax Simplification (OTS) published its long-awaited second report into inheritance tax simplification. Across 107 pages, the report 'explores the main complexities and technical issues that arise from the way [IHT] works'.
HMRC calculates that IHT will produce £5.5bn in 2019/20 and, from the Treasury's viewpoint, the tax is raised efficiently - only 22,680 estates will pay that bill.
Politically, as well as financially, it would be difficult for the new Chancellor to go beyond simplification and cut the IHT tax take. In practice, any revision looks unlikely before the (imminent) next election. The Labour Party is considering a new lifetime gifts tax that would charge recipients at income tax rates on gifts/inheritances above a lifetime threshold of £125,000.
The conclusion is that IHT in some form or another is here to stay and, in the way of tax simplifications and radical reforms (remember pensions?), may soon worsen. So, what can parents do now to pass on wealth to the next generation?
Skipping a generation
One starting point, particularly for older parents, is to consider whether the next generation is the right recipient. A gift from a grandparent to a grandchild may disappoint the passed-over parent, but it has the virtue of skipping one generation's IHT issues. It may also mean that investment of the gift attracts less tax than it would otherwise.
Whether or not there is scope for generation-skipping, the current IHT rules make lifetime gifts to children a sensible strategy. As a reminder, there are currently three basic regular exemptions:
- The annual exemption of £3,000, with a limited one year carry forward opportunity. The OTS has suggested that this exemption should be merged with the marriage allowance into a 'personal gift allowance'. The OTS report points out that the annual exemption alone would now be £11,900 had it been index-linked since it was last increased in 1981.
- The £250 outright small gifts exemption. The OTS would not change the basis of this exemption, but again highlighted how it has lost value. Last set in 1980, indexation would now bring it up to a more meaningful £1,010.
- The normal expenditure exemption, which exempts gifts that are regular, out of income and do not reduce the donor's standard of living.
The normal expenditure exemption is particularly valuable for those with surplus income, including income from ISAs, and can be a reason for choosing to take pension withdrawals rather than opt for nil drawdown. The OTS has suggested the exemption should be reformed by either:
- Removing the 'regular' requirement and a setting percentage of income limit (possibly based on tax return data); or
- Scrapping the exemption in favour of a larger personal gift allowance (£25,000 was used in an OTS example).
In terms of investment for children of gifted capital, there are two obvious options worth examining initially; Junior ISAs (JISAs) and pensions. Both have the advantage that they are outside the anti-avoidance rule that taxes a minor unmarried child's income back on a parental donor of capital if that income exceeds £100 per tax year.
JISAs first appeared in November 2011 as a quasi-replacement for Child Trust Funds. In 2019/20 the maximum JISA investment is £4,368 (meaning that £35,836 could have been invested to date).
JISAs have the same tax treatment as adult ISAs: there is no UK income tax on dividends or interest, no capital gains tax and no reporting to HMRC. The key difference from the adult ISA is access, as JISA funds cannot be accessed before age 18, other than in exceptional circumstances.
The child can start managing their JISA from age 16 (though not all providers permit this) and at 18 the JISA becomes an adult ISA with full access. That may not suit all (grand) parents.
While JISAs' popularity has grown in terms of the number of accounts opened, the latest HMRC statistics (issued August 2018) show that the total amount invested has been flatlining. That may be a reflection of the way in which JISAs have been invested.
The HMRC stats show that, in April 2018, 70% of all JISA monies were held in cash and, of the subscriptions for 2017/18, only 43% were directed to the stocks and shares component. Such percentages are very similar to adult ISAs, suggesting parental investment views are being imposed on their children. The logic is hard to justify, as almost by definition, children can afford to take a longer term investment view than their parents.
One overlooked quirk of the ISA legislation is that, although JISAs are available until a child's 18th birthday, the adult ISA is available from age 16, albeit only as a cash ISA before age 18. However, there is a sting in the tail of the £24,368 JISA/ISA opportunity. If the parent funds the ISA, then the anti-avoidance rules mentioned above apply to the ISA interest (but not the JISA interest, as previously mentioned). In a world of low interest rates and the personal savings allowance, that may not matter, but it is a point to watch.
Quick case study: JISA build up
Jason will reach his first birthday on 6 April 2020. His parents decide that they will start a stocks and shares JISA for him on 5 April and jointly contribute the maximum for 2019/20 of £4,368. The gift would be covered by their combined annual IHT exemptions if the normal expenditure exemption is not available.
If Jason’s parents continue to contribute the maximum each year for the next 18 years, then assuming:
- CPI inflation – and hence the JISA contribution limit – rises by 2% a year from 2020/21; and
- The JISA funds achieve an investment return of 4% a year after charges
Then by the time Jason reaches the age of 18, he will have an adult ISA worth £131,700. If his parents chose a cash JISA with a net return of 2%, Jason would receive over £20,500 less.
The children’s personal pension has been one of the by-products of the pension simplification (sic) rules that never took off in the way expected. In theory it had – and still has – plenty in its favour:
- 20% tax relief is automatically applied, so a £3,600 maximum contribution is a gift of only £2,880 – within the annual exemption – regardless of the tax position of the donor or child;
- There is no issue about access immediately the age of 18 is reached;
- Funds are free of UK income tax and capital gains tax;
- Up to 25% of the benefits can be drawn tax-free.
What has held child pensions back is probably the long-term commitment they represent, as benefits will not normally be available for the ‘child’ until they are within ten years of their state pension age. That could mean a minimum access age of 60 or more. A lot could happen in that timescale, not least in terms of pension legislation.
If that long term aspect is accepted, the case for starting pension planning early is strong, as an alternative take on Jason illustrates.
Quick case study: The long-term pension build-up
Jason’s parents decide that they will opt for a personal pension for their son rather than a JISA. They choose again to make the maximum possible contribution - £2,880 net and start one day before his first birthday, ending with a final contribution just before Jason reaches 18.
- There is no increase in the £3,600 contribution ceiling; and
- The personal pension funds achieve an investment return of 4% a year after all charges
Then by the time Jason reaches the age of 60, he will have a pension pot worth just short of £480,000. His parents’ total contributions will have been £51,840.
While there are many other investment opportunities for children beyond JISAs and pensions, both these routes have important advantages in terms of tax treatment and simplicity of administration which the alternatives often lack.
Aside from the additional business this could generate through existing clients, it will also enable you to start building relationships with the next generation of family members, and the importance of this should not be underestimated.
The not-so-little Jason may need advice on university fees/loans, workplace pensions, mortgage protection and of course that child pension you advised his grand/parents to contribute into for him all those years ago.
But it will potentially be of greatest value when his grand/parents die and he inherits their wealth, as you are far more likely to keep those assets under your advice. Additionally, the value of a business that encompasses multiple generations will be much higher than one where the core client bank is in retirement.
Andy Woollon is wealth specialist at Zurich UK