Individual Savings Accounts (ISAs) are a popular way for UK residents to save and invest tax-efficiently. They allow us to earn tax-free income and benefit from tax-free growth and tax-free withdrawals. Effectively, they protect our money from being taxed. Or do they?
A common question regarding ISAs and tax relates specifically to the rules on inheritance tax. So let’s explore this in more detail to understand how ISAs fit into estate planning.
Quick Takeaways:
● ISAs are subject to the rules of inheritance tax, and their tax-free status ends upon the holder’s death.
● A spouse or civil partner can inherit their deceased partner’s ISA allowance, preserving tax-free growth.
● Certain types of investments in ISAs may offer reduced rates of inheritance tax after a two-year holding period.
● Executors (those managing the assets of somebody who has passed away) should follow HMRC guidelines to handle ISAs correctly on death.
Understanding Inheritance Tax (IHT) and ISAs
Inheritance Tax (IHT) looks at the value of our estate. Now we’re not talking about larking about a country manor. We’re looking at the value of our stuff.
When we pass away, inheritance tax applies to the total value of our property, cash, possessions, and investments above a certain threshold. Currently, the IHT rate in the UK is 40% on the value of the estate above £325,000. This threshold is called the Nil Rate Band (NRB) and may vary depending on individual circumstances, such as the presence of a spouse or civil partner and if we own a property that we are giving to a child or grandchild.
There are various types of ISA, including Cash ISAs, Stocks and Shares ISAs, Innovative Finance ISAs, and Lifetime ISAs. As mentioned, they offer tax advantages during our lifetime. However, while ISAs provide tax benefits while we’re alive, their tax treatment on death differs, especially regarding inheritance tax.
Are ISAs Subject to Inheritance Tax?
Contrary to popular belief, ISAs are generally not exempt from inheritance tax. But that doesn’t mean inheritance tax is applied to them in all cases.
When the account holder dies, the value of their ISAs is included in their estate for IHT purposes, potentially pushing the estate over the tax-free threshold. So we have to think about ISAs being part of the value of our overall estate.
For instance, if you have a £50,000 ISA and pass away, that £50,000 is added to the rest of your estate's value to determine if any inheritance tax is due. If the total estate, including the ISA, exceeds the IHT threshold, a 40% inheritance tax could be applied to the amount above the threshold. However, there are some strategies and exceptions that could reduce or eliminate the inheritance tax on ISAs.
Inherited ISA Allowance and Transfer Rules
One significant relief for married couples and civil partners is the Additional Permitted Subscription (APS). APS is a rule that allows a surviving spouse or civil partner to inherit the deceased partner’s ISA allowance, effectively transferring the tax-free benefits to them.
For example, if someone passes away with £50,000 in ISAs, their spouse or civil partner can inherit an additional ISA allowance equal to that £50,000, on top of their own annual ISA limit. Note that if your partnership is not legally recognised, APS won’t be available.
To use the APS, the surviving spouse or civil partner must contact the ISA provider to transfer the funds and complete the necessary paperwork. The allowance is transferable, but it doesn’t mean the ISA funds themselves are exempt from IHT. It simply allows the surviving partner to continue enjoying the tax-free growth and income benefits of the ISA.
Special Types of ISAs: AIM ISAs and BPR-Qualifying Investments
While most ISAs are subject to general inheritance tax rules, there is a special case for Stocks and Shares ISAs invested in specific types of assets, such as shares in qualifying companies on the Alternative Investment Market (AIM). Shares in AIM-listed companies may be eligible for Business Property Relief (BPR), which provides a 50% IHT relief on certain investments if held for at least two years before death and still hold the investments when you die.
BPR is a government scheme designed to encourage investment in small and medium-sized UK businesses. If your ISA is invested in BPR-qualifying shares, such as some AIM stocks, those shares could be exempt from IHT after the required two-year holding period. However, AIM shares can be more volatile than other investments, so this strategy carries additional risk.
What Happens to an ISA Upon Death?
When an ISA holder dies, their ISA is “frozen,” meaning it no longer receives tax-free treatment. Any growth, income, or interest earned after the account holder’s death may become taxable until the funds are distributed to beneficiaries or transferred to a spouse under the APS rules. Generally, the ISA is closed, and the assets are transferred to the estate to be distributed according to the will or intestacy laws.
The executor or estate administrator should inform the ISA provider of the death and follow their procedures for closing the account and distributing the funds. After this, the assets are subject to IHT unless specific exemptions (such as BPR) apply.
Stocks and Shares ISAs and Inheritance Tax
Stocks and Shares ISAs can include various types of investments, from shares to bonds. Inheritance tax rules apply to the total value of these investments upon death. However, the inherited stocks and shares’ holding period may affect the tax treatment for the beneficiary.
When a person inherits stocks or shares, the IHT is based on the value at the time of the original holder’s death. The beneficiary may also have to pay capital gains tax on any gains if they later decide to sell the inherited shares. It’s crucial for beneficiaries to speak to tax advisers to understand their tax obligations when inheriting ISA-held investments.
Tax-Free Investments vs. Inheritance Tax Liabilities
ISAs offer tax-free income and growth during a person’s lifetime, but this does not mean they are exempt from inheritance tax. There are other IHT-efficient investments, such as Trusts or certain life insurance policies, that are designed specifically to reduce inheritance tax liabilities. Comparing ISAs with these other investments can help people make informed decisions for estate planning.
If you’re looking to minimise IHT, combining ISAs with other tax-efficient estate planning strategies might be a better approach. Financial advisers can provide personalised strategies that help optimise both tax benefits and inheritance consideration.
ISA Rules and HMRC Guidance on Death
HMRC has specific guidance on how ISAs are treated upon death. Executors or administrators are responsible for handling the deceased’s ISAs according to these rules. They must declare the ISA's value as part of the estate for IHT purposes and follow any specific steps the provider outlines.
Missteps in managing the deceased’s ISAs, such as failing to inform HMRC or the ISA provider, can lead to complications, including penalties or tax liabilities. Executors should review HMRC’s guidelines carefully or seek advice to ensure compliance with ISA inheritance rules.
Junior ISAs and Inheritance Tax
Junior ISAs (JISAs) are designed for children under 18. While the child holds the account, it is managed by a parent or guardian until they reach adulthood. If a JISA account holder passes away before 18, the ISA will generally be included in their estate for IHT purposes.
However, due to typical thresholds, JISAs are less likely to attract IHT unless the child has other substantial assets. This could be a useful way of reducing your own IHT liability while gifting money to a child.
Summary
To recap, ISAs are not exempt from inheritance tax, and their tax-free benefits cease upon the holder’s death. The Additional Permitted Subscription (APS) allows spouses and civil partners to inherit ISA allowances, but unmarried partners do not qualify for this benefit. Special ISAs, such as those invested in BPR-qualifying AIM shares, may offer reduced rates of inheritance tax if held for a minimum period.
Understanding the rules surrounding ISAs and inheritance tax is essential for making informed decisions about estate planning. With the right approach, you can help ensure your assets are passed on efficiently while minimizing tax liabilities.
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