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How ISAs can help reduce your inheritance tax bill

Joanna Faith
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Joanna Faith

If you’re looking to reduce the size of the inheritance tax bill on your estate, ISAs can help.

Inheritance tax is often described as “the most hated tax” as it’s thrust upon families who are struggling with bereavement.

Dubbed the death tax, inheritance tax is a tax on the estate – that’s the property, money and possessions – of someone who has died.

It is charged at 40% on anything above £325,000, the current threshold.

However, there are plenty of ways to reduce the inheritance bill for your beneficiaries.

Here we explain how ISAs can help.

Save as much as possible in an ISA

ISAs are a great way of keeping the taxman away from your savings while you’re alive but they’re also tax efficient when you die – assuming you’re survived by a spouse.

When you die, no more money can be added to your ISA, but your pot can be transferred to your spouse free of inheritance tax.

This isn’t the case for savings outside an ISA. These would count towards your nil rate band – your tax-free inheritance tax allowance.

Another benefit worth mentioning is that if your ISA is transferred to your spouse, it won’t eat into their annual ISA allowance. Instead, they’d get an extra allowance for one year equivalent to the size of the ISA the spouse left. This is known as ‘additional permitted subscription’.

Despite the obvious advantages of transferring ISAs, this tax break is underused by couples. In 2017/18, the latest data available, 25,000 people made use of the inheritable ISA, less than a fifth of those eligible.

“Perhaps because the process can be a bit complicated or isn’t that well known,” says Laura Suter, personal finance analyst at investment platform AJ Bell.

Gift money into a junior ISA

Another way to reduce the size of your estate for inheritance tax purposes is gift money into an ISA for family members while you’re alive. Everyone can gift up to £3,000 a year without it being considered as part of your estate. Anything above this amount will be treated as part of your taxable estate if you die within seven years of making the gift.

You could gift the £3,000 into one or more junior ISAs for your children or grandchildren.

You can carry forward any part of your gift allowance which isn’t used in the tax year to the following tax year, but it can’t be carried over any further.

Wealthier people with surplus income can gift unlimited amounts of money as long as they can prove the gift hasn’t affected their standard of living.

“The rules are very vague, and you have to be comfortable you’re not gifting too much but it means you could potentially gift the entire junior ISA allowance each year for your children or grandchildren, which is currently £4,386,” says Suter.

Invest in AIM-listed stocks

Another option is to hold shares traded on the Alternative Investment Market (AIM) in your ISA. AIM is a sub-market of the London Stock Exchange and home to fledgling businesses.

Most shares traded on AIM qualify for business property relief, which means they can be passed on free of inheritance tax if you’ve held them for at least two years.

Suter says: “Since 2013 you can hold these stocks in an ISA, meaning you benefit from them being income and capital gains tax free during your lifetime, but also get the inheritance tax benefits after your death.

“However, these stocks should be held by experienced investors and as part of a bigger portfolio as they are smaller companies and so more volatile than some other investments.”

The inheritance tax exemption only applies to directly held AIM shares not those held within a fund.