Inheritance tax planning within an ISA wrapper

In this article, I thought I’d talk about ISAs.

Specifically, a scenario we see fairly often at Octopus, which is probably familiar to you as well. An older client has diligently saved into their ISA for many years, building up a significant pot of wealth in the process. It’s easy to understand from the client’s perspective why they don’t want to contemplate taking wealth out of their ISA wrapper, even when it becomes highly unlikely that the ISA will be required to cover their needs during the rest of their life.

That often leaves the ISA pot facing a 40% inheritance tax bill when they die. Our recent research has shown that 79% of ISA investors surveyed didn’t realise that their ISA could be subject to inheritance tax¹, the assumption being that “tax free” extends to inheritance tax as well.

So here’s a way you can help a client to plan for their estate while leaving their ISA pot in place within the ISA wrapper.

Barry wants to keep his ISA

Barry is a homeowner. He’s 72, mortgage-free, and receives an income from his defined benefit pension plan that covers his needs. He is unmarried, and plans to leave everything to his son Peter.

Barry has been a committed ISA investor since ISAs began in 1999. Before that, he regularly saved into a PEP. He now has a Stocks and Shares ISA portfolio worth £200,000, as well as £50,000 in his Cash ISA, which has built up in recent years through profit-taking on investment positions.

At his review, Barry mentions to Claire, his financial adviser, that he is concerned about inheritance tax. He had always thought of his ISA as being tax-free, and until recently never gave consideration as to whether that included inheritance tax. Claire confirms that, yes, as things stand, Peter would expect to pay 40% inheritance tax when he inherits Barry’s ISA assets, since Barry’s home would use up his allowances.

Barry replies that, ideally, he would like to find a way to invest that retains the tax benefits of an ISA wrapper but without the inheritance tax liability.

Claire recommends a solution

Based on Barry’s objectives and attitude to risk, Claire recommends transferring his Stocks and Shares ISA to an AIM Inheritance Tax ISA specifically managed to invest into companies that qualify for Business Relief (BR), a longstanding relief from inheritance tax. Barry remains keen to invest for the long term and is comfortable with any short-term volatility. He understands that an AIM Inheritance Tax ISA is significantly higher risk than most normal Stocks and Shares ISAs.

A BR-qualifying AIM Inheritance Tax ISA invests in a selection of companies listed on the Alternative Investment Market (AIM). Companies are chosen that fit the criteria for qualifying for BR.

Since 1996, private investors have been able to hold shares in AIM-listed companies and pass them on free from inheritance tax, provided the company qualifies for BR, and provided the investor has held the shares for at least two years when they die. In 2013, it became possible to hold AIM shares in an ISA. As a result, for the last seven years it has been possible to either make new subscriptions or to transfer some or all of an existing ISA pot into an BR-qualifying ISA. Since 2013, Octopus has helped over 12,000 investors invest into AIM-listed shares in this way.

A specialist manager is essential

Claire makes clear that her recommendations means Barry’s portfolio being managed by a specialist investment manager. At first, Barry is a bit disappointed. He has always enjoyed choosing the investments in his ISA and deciding when to buy and sell. However, Claire explains that the investment manager would not only be choosing the stocks from an investment perspective from those listed on AIM, which is a specialist market, but would also monitor the portfolio to check that every company is expected to qualify for BR. Barry agrees that this is a skillset he doesn’t have and is happy to have an investment manager manage his portfolio.

Barry understands his capital is at risk

Claire also explains to Barry that he should consider this to be a long-term investment. The tax relief afforded to BR-qualifying investments is designed to offset some of the risks of investing into qualifying shares listed on AIM. The value of his new ISA portfolio, and any income from it, can fall or rise, and he may not get back the full amount he invests. Claire also makes Barry aware that AIM-listed shares can go up and down in price by more than shares listed on the main market of the London Stock Exchange. They can also be harder to sell.

She explains that HMRC will assess whether each company in his portfolio qualifies for BR when he dies. Entitlement to the relief will depend on the companies qualifying for BR when he dies. She explains that the value of BR to his estate will depend on the value of his whole estate at that time, and that, like all tax legislation, the rules applicable to BR could change in future.

After two years, Barry’s portfolio is zero-rated for inheritance tax

Barry is happy to transfer his stocks and shares ISA. He expects to hold this investment portfolio until he dies and is comfortable taking these risks in order to pursue his estate planning objective. Barry transfers his Stocks and Shares ISA into an AIM Inheritance Tax ISA. Once he has held the shares in his new portfolio for two years, they should be zero-rated for inheritance tax. From then on, Barry can continue to hold his portfolio in the knowledge that he can pass it on to Peter without expecting it to add to the inheritance tax bill that will be due on his estate.