How to protect this one important tax break
Inheritance Tax has been a hot topic of late, due to rising bills and recent government proposals to tax pension savings. This is a significant blow for those who’d hoped to pass on tax-free pension savings to their children or grandchildren.
What’s more, the changes may also affect their eligibility for another tax break – the Residence Nil Rate Band (RNRB). Here, we highlight how good financial planning can help.
This is important for anyone with assets, including property and pension savings, of £2 million plus. The article is relevant today, under current tax rules, and the proposed pension changes mean that many more people are likely to be affected from 2027.
What is the Residence Nil Rate Band (RNRB)?
The RNRB was introduced in 2017 and aimed to ease the burden of Inheritance Tax on families, particularly those whose main asset was the family home. It provides a tax-free allowance, currently £175,000, when a home is passed on to direct descendants. This is in addition to the standard Nil-Rate Band (NRB) of £325,000, and means an individual can pass on up to £500,000 tax-free. The remainder of their estate will generally be taxed at 40 per cent. So, an estate benefiting from the full RNRB will pay £70,000 less tax. However, there are restrictions.
Who can benefit from the RNRB?
It applies where property transfers to direct descendants, including stepchildren and adopted children. This is true even when someone has already sold or given away their home, or downsized – providing this was after 8 July 2015.
However, the RNRB does not extend to larger estates. When the estate’s value exceeds £2 million, the RNRB tapers away by £1 for every £2 over £2 million. This means that this extra relief does not apply to estates of £2.35 million and over (or £2.7 million for a couple).
The home need not be in the UK but it does have to be within the scope of UK Inheritance Tax. It must also be included in the estate.
How can you protect your RNRB and reduce tax paid?
‘There are many ways of cracking this,’ says Paul Willans, Managing Director of AJB Wealth. ‘The key is to reduce the value of the estate to below £2 million. When you make gifts, it’s generally seven years before they become 100 per cent free of Inheritance Tax. However, they are effective immediately for the purposes of RNRB. Using gifts to reduce the size of the taxable estate could reduce the tax bill by £70,000, or £140,000 for a couple.’
An example of how this works
Sarah and James Bridge, both 65, have a home worth £1 million, a pension fund of £800,000 and investments of £525,000. They intend to leave everything to their children.
Under the current rules, their pension is not included in their estate, which is valued at £1,525,000. They are eligible for both the NRB and the RNRB, meaning that Inheritance Tax at 40 per cent is payable on just £525,000. The tax payable is £210,000.
Under the proposed new rules, due to come into effect in April 2027, their pension fund would be included in their combined estates. The total value of their estates is now £2.35 million and their eligibility for the RNRB is reduced.
They’re still entitled to the NRB (£650,000) but have a RNRB of just £175,000. This means tax is payable on £1,525,000 and amounts to £610,000. The tax bill has increased by £400,000.
‘One option here would be to draw income from the pension and place £350,000 of the investments into trusts for your desired beneficiaries,’ says Willans. ‘This would reduce the estate to below £2 million, and make it fully eligible for the RNRB, potentially saving £70,000. What’s more, the investment growth of the money in trust is free from IHT and the gifted sum will fall out of the IHT net after seven years. This potentially saves a further £140,000 in IHT.’
Can the RNRB be transferred to a surviving partner?
Assets can pass tax-free to a surviving spouse or civil partner. Where there is unused RNRB, it can also be transferred along with the Nil Rate Band. This means that a couple can pass on £1 million without paying tax.
If a surviving spouse remarries, they’re still entitled to carry forward any unused RNRB from their first spouse. This means that it’s possible that their descendants may in effect benefit from three RNRBs. However, a maximum of two can be used at any one time.
In conclusion
The proposed Inheritance Tax changes may have unintended consequences. At present, the details are not yet known, so it’s important not to make any hasty decisions. However, it pays to be well informed in this area. Even as things stand today, families with property and investments of £2 million should consider action to protect their entitlement to RNRB.
‘People aren’t necessarily aware of their total net worth, let alone the detailed rules around Inheritance Tax,’ says Willans. ‘It’s prudent to assess your situation on a regular basis and consider taking professional advice – if only to ensure that your financial affairs are in the best possible order.’
Would you benefit from a review of your overall financial situation? AJB Wealth is well-placed to assist. Please book an exploratory meeting, or call us on 01428 774 070.
Important: The content of this bulletin is for general consideration only and does not constitute advice. No action must be taken, or refrained from being taken, without advice. This company accepts no responsibility for any loss occasioned as a result of any such action, or inaction. References to tax rates and allowances are based on current tax law and are subject to change.
