Who wouldn’t want to be an ISA millionaire?
Over the past few years a growing number of stories have appeared of people lucky enough to have joined the club. Well, luck is only part of it, because this group have saved and invested regularly and diligently, and their efforts have paid off. They should be understandably pleased.
The trouble is, holding £1 million in ISAs is not necessarily the most sound of financial strategies. ISAs are undoubtedly a core part of sensible financial planning – providing a tax-efficient (Free of Income Tax and Capital Gains Tax) way to save with an enormous choice of investments available and a generous annual allowance. But investors must remember that tax-efficient is not the same as tax-free. Once ISAs start getting to a certain size there is another side to their story, remember a £1 million ISA could generate a £400,000 Inheritance Tax (IHT) bill.
Let’s consider the profile of the typical ISA millionaire.
On average, they would be expected to be older rather than younger, diligent and organised with their finances, and either a savvy investor or have received sound investment advice. How else could they have reached the million-pound milestone with a tax wrapper with a current annual limit of £20,000. Given that they have £1 million in ISAs, it might be reasonable to assume they also own a property, and it seems unlikely they would still have a mortgage of any substantial size.
As an example, let’s consider a married couple who fit this profile, are both age 65 and own a mortgage-free home worth £500,000. Let’s assume they have no other property, cars worth £30,000, household contents of £40,000 and £50,000 in their bank account. This brings the total value of their estate to £1,620,000.
Their available combined nil rate band (NRB) for IHT is £650,000. If they have children or grandchildren they may also have a combined Residence Nil-Rate Band (RNRB) of £300,000, leading to a current IHT liability of £268,000. Assuming investment asset growth of 5% per year and IHT allowance increases of 2% a year after 2021, in 10 years’ time they could face an IHT liability of £627,847 (see table).
It’s worth remembering that people without children or grandchildren will have a higher IHT liability because they won’t be able to use the RNRB, and also that the RNRB tapers off for people with estates worth more than £2 million. In this example, if our couple were childless their IHT liability would be £388,000 today and could be £745,223 in ten years’ time.
Potential IHT liability of example ISA millionaires
|Married couple with children||Married couple with children,
£662,000 moved from ISAs to Trust
|Cash in bank account||£50,000||£50,000|
|Total Net assets||£1,620,000||£958,000|
|Less current NRB||– £650,000||– £650,000|
|Less RNRB||– £300,000||– £300,000|
|Amount chargeable to IHT||£670,000||£8,000|
|IHT liability in 7 years, based on current estate value||£268,000||£3,200|
|Potential IHT liability in 10 years’ time*||£627,847||£146,406|
* Assuming asset growth of 5% per year and IHT allowance increases of 2% a year after 2021.
Source: WAY Investment Services Inheritance Tax Calculator
What could you do to reduce this liability?
One option is moving some of their ISA holdings into Trusts.
Let’s consider the situation if they had each encashed £662,000 of their £1 million ISA and then gifted £331,000 each via a flexible lifetime Trust. The gifts into trust are immediately outside of the calculations for RNRB purposes, reducing their IHT liability in 7 years to just £3,200, based on today’s estate value (see table). Investment growth from the trusts would be immediately outside of their estate for IHT purposes, and seven years later the full value of both trusts would be outside of their estates too.
Using the same assumptions as before, in 10 years’ time their IHT liability could have increased again to £146,406. However, they could use their respective NRBs again in seven years’ time. They also have the life expectancy, on average, to recycle their NRB’s a third time during lifetime (if necessary) and still have their NRBs returned for use on their demise.
For comparison, typical charges for a Trust might include an initial charge of £2,000, an ongoing annual charge of 1% p.a. capped at £2,200 (including VAT and professional trustee service). Underlying fund choice and costs could be identical to their ISA investments which already incur fund management charges. Trusts may be subject to Capital Gains Tax, but only if the relevant allowances were exceeded.
Some may be interested in transferring to an Alternative Investment Market (AIM) ISA, but a note of caution. By definition, AIM shares are higher risk investments and should only be considered for those people with the appropriate appetite and tolerance for such risk. The investments would need to be held at death (which could be decades later) for any IHT exemption to apply – and there are umpteen reasons why such high-risk investments may not be held continuously for such a potentially long period of time.
In addition, as the investor still ‘owns’ the investment (unlike with gifting), investments in an AIM ISA always form part of the estate for the calculation of the RNRB, so this valuable exemption could be lost.
In practice, reaching £1 million is arguably too late a trigger point to consider the IHT implications of an ISA. Depending what other assets and liabilities a client has, it may be appropriate to start considering alternative strategies when ISA wealth reaches, say £500,000. Retirement is a natural trigger point to consider IHT, and therefore ISAs – but in fact any discussions about IHT should also involve questions about ISAs, and the sooner the better.
The message is simple. To the growing number of lucky people with ISA pots worth £1 million – congratulations. It may now be time to think about making new plans, and even those with less than £1m should be made aware of the IHT risk.
If you have a question prompted by this article, please get in touch.
Article credit: John Humphreys, Inheritance Tax Specialist, WAY Investment Services