Financial planning in the twilight zone

Sci-fi fans may remember the oft-repeated sixties TV series, The Twilight Zone. Each episode — often a futuristic morality tale — opened with a narrator’s monologue in which the twilight zone was described as “a land of both shadow and substance”.

In financial planning there is also a twilight zone. More down-to-earth than the fictional version, it is the point between someone dying and their estate being distributed. This is a sensitive time for many families, who may be deep in mourning. But, for those ready to focus on fiscal practicalities, it presents opportunities to save thousands of pounds in tax.

A very basic introduction to the world of probate may be useful. When you die, the executors of your estate apply for probate — the legal right to distribute your assets. In Scotland it is called “confirmation” but the process is similar to England and Wales and the tax benefits discussed below apply.

One of the most important things they must do is value your estate to establish whether any inheritance tax (IHT) is due and if there are any outstanding debts to settle. It is usually sensible to deal with both before distributing cash to beneficiaries.

Your estate is valued for tax purposes on the date of your death. It can take a year or more to distribute the assets — our twilight zone period. So what do you need to know?

Deed of variation

A deed of variation allows beneficiaries, with the agreement of the executors, to retrospectively alter the terms of a will so that all or part of their share goes elsewhere.

If Granny has left all her cash to a cats’ home, it won’t allow you to redirect it to your pockets. But for some beneficiaries a big inheritance is more of a burden than a blessing. They may already have enough for their own needs and will only pass the money on to the next generation when they die. The biggest beneficiary in this scenario might be HM Revenue & Customs.

Let’s say Granny leaves you £1mn, subject to IHT at 40 per cent. You inherit £600,000. If in turn you leave this to your children on your death and IHT is charged again they will receive just £360,000 — 64 per cent will have gone in taxes. A deed of variation allows you to forgo your inheritance by changing the terms of the will so the money goes directly to your children. You effectively skip a generation for tax.

You may be unsure whether you might need the inheritance yourself — to meet later-life care costs, for instance. You can use a deed of variation to direct the money into a discretionary trust. This way the trustees can draw on it for your benefit if required or make distributions to other beneficiaries. This money will not count in your estate for IHT purposes when you die.

You can also use a deed of variation to redirect cash to charity. I have a client whose father died recently. He had left £100,000 — 5 per cent of his net estate — to a group of charities.

She used a deed of variation to double all the donations, lifting the gift to £200,000. You might think that this would have cost her £100,000, but she was actually £12,000 better off.

When you gift 10 per cent of your net estate to one or more registered charities the rate of IHT is reduced from 40 per cent to 36 per cent. So:

• The net estate was £2mn; the original charity gift was £100,000, leaving £1.9mn to my client. After IHT she would have been left with £1.140mn.

• By giving £200,000, £1.8mn was left to my client. After IHT at the reduced rate, she was left with £1.152mn.

People often like to leave a specified sum to charities. If the value of your estate rises between executing your will and death, the intended donation may fall short of the 10 per cent threshold that triggers a reduction in IHT. If you leave between 4 per cent and 10 per cent of your net estate to charity your beneficiaries will be better off with you giving the full 10 per cent. A deed of variation can enable beneficiaries to take advantage of this IHT charity reduction.

A deed of variation can also help you reduce capital gains tax (CGT). Perhaps you inherited a holiday home. You know you will sell it at some point, but you and your family would like to enjoy it for a few years first. When you do dispose of it you will be liable for CGT on any increase in its valuation since the original owner died.

You can offset your annual CGT allowance against this gain. With a deed of variation you could ensure that you are not the sole beneficiary — you might split the house between you and your children. That way, when you come to sell it you may also have their CGT allowances to offset against the gains.

Though you have two years in which to make a deed of variation, it is generally sensible to make the requisite decisions before the money is distributed — which could be sooner than two years. Discuss these issues as early as possible with your adviser, the probate lawyer and the executors.

Capital gains

When you die, any capital gains accrued up to the point of death are “washed out”. The slate is wiped clean. Helpfully, HMRC then gives your ghostly self — your estate — a new CGT allowance.

Assets may grow in value between death and completion of the estate administration, potentially causing a CGT issue should you wish to liquidate them. The executors may dispose of some of them to use the estate’s CGT allowance — £12,300 in the tax year of death and in the following two tax years.

Exploiting losses

More recently, the stock market correction has meant the challenge has been losses rather than gains. A client of mine recently inherited a portfolio of shares from his mother. Between her death and distribution their value fell by £50,000. The shares were unsuitable for my client, and he asked the executors to sell them to release cash to buy something more in line with his needs and attitude to risk.

On disposal of the assets the executors went back to HMRC and applied for the IHT to be recalculated, based on the lower sale value. They received a £20,000 rebate.

In calculating the lower value you must take into account the cumulative amount of assets the executor sells in the 12 months after death. So, with IHT rates being higher than CGT rates, you may have to be quite forensic — only having the executor sell the shares that have lost value to create a cumulative loss and then applying to HMRC for a rebate.

The rules are complex, and this is the territory of a good probate lawyer, who should know everything I have covered and more. But, as with the original Twilight Zone, there is a moral to this tale. Don’t just rely on your lawyer to raise these points. I always encourage my clients to be proactive in these cases. Negotiating this tricky terrain can often save them thousands of pounds.

Charles Calkin is a financial planner at wealth manager James Hambro & Partners