How to protect your ISA holdings from a hefty Inheritance Tax bill

How to protect your ISA holdings from a hefty Inheritance Tax bill
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One of the best things about being an investor in the UK is that every year, you get a tax-free ISA allowance of £20,000. You can put your allowance into different types of investments within an ISA and earn completely tax-free returns. This provides a great way to build wealth. In fact, recent figures reveal that there are around 2,000 ISA millionaires in the UK with average holdings of more than £1.4 million.

However, while many people are aware of the tax advantages of ISAs, what some don’t realise is that ISAs lose their tax-efficient status when the owner dies.

In other words, if you have an ISA, your beneficiary may not benefit from tax-free income and growth. Furthermore, they could be looking at a hefty Inheritance Tax bill on the ISA. Indeed, according to the Wealth Club, the heirs to the 2,000 ISA millionaires in the UK could be looking at a collective IHT bill of £1.1 billion, or about £564,000 each.

Luckily, there are ways to get around this. Read on to find out more.

What happens to your ISA when you die?

When you die, your ISA will continue to benefit from the tax advantages of an ISA until one of the following events occur:

  • The administration of your estate is completed
  • Your executor closes the ISA

If neither of these events occurs within three years of death, the ISA provider will close it.

If you are married or in a civil partnership, the good news is that you can transfer your ISA to your spouse or partner without losing the benefit of tax-free income and growth. This is achieved through something called the Additional Permitted Subscription (APS) allowance.

APS is essentially a one-time additional ISA allowance equal to the value of your ISA at the time of your death or the day your ISA is closed. The allowance has no bearing on your partner’s ISA allowance.

What about Inheritance Tax?

Your ISA will be counted as part of your estate. If your estate is worth more than the current Inheritance Tax limit of £325,000, your ISA may be subject to Inheritance Tax.

How can you protect your ISA from Inheritance Tax?

If you leave your ISA to your spouse or civil partner, they won’t have to pay Inheritance Tax on it.

It’s also possible to avoid paying this tax if your beneficiary is someone other than your spouse or civil partner. This, as explained by the Wealth Club can be accomplished by transferring the ISA, including the previous years’ allowances, into a portfolio of Alternative Investment Market (AIM) shares.

Basically, some AIM shares held within a stocks and shares ISA may qualify for 100% Business Property Relief (BMR). This effectively makes them free of Inheritance Tax. However, the shares must be held for at least two years to qualify for zero Inheritance Tax. Not all AIM shares are eligible for this tax relief. So do your research before you make the switch.

If that sounds like too much work, you can alternatively invest in an AIM ISA portfolio. This is basically a pre-packaged portfolio of qualifying AIM shares managed by professional managers.

According to the Wealth Club, AIM ISAs that could be worth checking out, include:

  • Octopus AIM IHT ISA
  • RC Brown AIM IHT ISA
  • Stellar AIM IHT ISA

What are the risks of AIM shares?

Switching your ISA to a portfolio of AIM shares can protect your beneficiaries from a potentially large Inheritance Tax bill. However, these shares are not without risk.

AIM companies, as opposed to those on the main LSE market, are smaller and more volatile, according to the Wealth Club. As a result, they pose a greater risk.

This risk can be mitigated by investing in professionally managed AIM ISAs, like the ones mentioned above. These are likely to be well diversified. Some could be spread across as many as 40 different stocks, which helps to reduce the level of risk.

AIM ISAs are recommended for people over the age of 60 who are still contributing to a stocks and shares ISA but do not intend to spend it and are thus concerned about Inheritance Tax.

According to the Wealth Club, a couple with each person contributing the maximum allowed allowance of £20,000 every year into an AIM ISA can amass a tax-free and Inheritance Tax-free pot of almost £1.5 million in 20 years (assuming 1.25% annual management fee and 7% annual growth).

Please note that tax treatment depends on the individual circumstances of each individual and may be subject to future change. The content of this article is provided for information purposes only. It is not intended to be, nor does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

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