When George Osborne offered the public a chance to “pass on your Isa tax free” in late 2014, a casual listener might have expected a big step-up in the generosity of the tax break for savers.
In fact, the change introduced by the former chancellor in his Autumn Statement speech was relatively modest. At a cost of £5m a year, the reform preserved the tax-free status of Isas when, on the death of a saver, they were passed on to a spouse. It had very few implications for Isas left to anyone else.
Even so, the move was widely welcomed. Those aged over 85 hold 5 per cent of their entire wealth in the form of Isas, a higher proportion than any other age group, according to the Institute for Fiscal Studies, an independent think-tank. Preserving the tax-free “wrapper” meant that a widow or widower would not be faced with tax bills if they inherited an Isa from their spouse.
The mechanism initially used to preserve the tax status was “clunky but well-intentioned”, according to Danny Cox, chartered financial planner at Hargreaves Lansdown. From April 2015, the surviving spouse received an extra one-off Isa allowance equal to the amount held in their deceased partner’s Isa to shelter income and capital gains from tax.
The same principle will apply to the Lifetime Isa, the new vehicle that, from April, will give young savers a government bonus of up to £1,000 each year. If a Lisa saver dies, their husband or wife will be given an “additional permitted subscription” equal to the amount held in the Lisa — including any government bonus it had earned.
The money would no longer be inside a Lisa wrapper, so no government charge would apply on withdrawals. The individual could use the money — if eligible — to pay up to £4,000 a year of this into their own Lisa but this would be subject to the normal subscription criteria.
Some of the clunkiness in this mechanism for preserving the tax status of Isas is about to be smoothed out. HM Revenue & Customs has recently published draft regulations that will result in Isas retaining their tax advantages for up to three years after the saver’s death, while the administration of the estate is being finalised.
These changes do not alter one of the limitations of Isas: despite the increasing generosity of the tax break, which can shelter ever-larger sums from income and capital gains tax, it does not extend to inheritance tax. While assets left to a spouse or civil partner are not subject to inheritance tax, Isas left to anyone else are taxed if the value of the estate exceeds the tax-free limit.
In this respect, Isas have a less favourable tax treatment than pensions, as pension pots can now be passed on to more beneficiaries — not just a spouse or civil partner — free of tax. This might persuade some people to spend their Isa funds first, in the hope of leaving a larger tax-free sum to their beneficiaries.
But the rules are complex and there are potential traps for the unwary. Jonathan Drysch, associate director of wealth planning at Killik & Co, an advisory firm, says: “Although there could be an argument for utilising Isas before pensions for IHT purposes, there are other factors which would need to be considered, such as potential income tax and lifetime allowance tax charges.”
Another possibility for those wanting to reduce IHT on the wealth they built up in their stocks and shares Isas is buying shares in companies on the Alternative Investment Market (Aim), many of which qualify for business property relief if owned for at least two years before death.
Lee Clark, divisional director for financial planning at Brewin Dolphin, an advisory firm, says investing in Aim shares can be an attractive option for less risk-averse clients. “Aim shares can be a very effective planning tool for those with significant Isa assets. It is not the only option, but it could be considered along with other options.”
This route is not for everyone, according to Mr Cox. “Aim stocks generally are quite risky. They can be much more volatile and the corporate governance is not as strict.” Joan Foster of RSM, an accountancy firm, agrees, adding that it is rare to see Aim shares used in this way. “Isa investors are relatively risk averse.”