How to make your ISA IHT free

With ISAs, the tax sting is in the tail. They’re very tax efficient during your life, but on your death (or your spouse’s death if later) your fund could be subject to inheritance tax (IHT) at 40%. 

As many as 75% of investors don’t realise this and unwittingly fall into this trap. 

But you don’t have to. There is a way to retain the ISA tax benefits you currently enjoy whilst at the same time protecting your money from inheritance tax. 

This is possible when you invest in an AIM Inheritance Tax ISA. 

What is an AIM Inheritance Tax ISA?

An AIM Inheritance Tax ISA is a portfolio of AIM shares designed to be held in an ISA and offer IHT protection. The portfolio is built and managed by a professional manager:

• You can benefit by investing your ISA allowance (currently £20,000) or transferring existing ISAs (unlimited amounts)
  
• Whilst you’re invested, any growth and income are tax free
  
• If your circumstances change and you want or need some of that money, you can take it out. The amount you withdraw will no longer be IHT free and the value of your ISA will depend on performance. Also, AIM shares are more risky and less liquid than ordinary shares so your portfolio will usually take longer to sell
  
• After your money has been invested in the portfolio for at least two years, it should become IHT free

Why could they be IHT free?

The portfolio invests in AIM companies that qualify for something called Business Property Relief, BPR in short. 

BPR was originally created to allow family businesses to be passed on through the generations IHT free, but it has been extended since. Today many (but not all) AIM companies enjoy this perk. 

As a result, if you hold shares in AIM companies that qualify for BPR for at least two years and still hold them on your death, no IHT will be due. 

Just to clarify: BPR has been around for years and investors have been taking advantage of it for over a decade. What is relatively new is the ability to combine the IHT relief granted by BPR with the ISA tax benefits of tax-free income and growth. 

It’s only since August 2013 that new rules have allowed AIM shares to be held in an ISA, thereby making the IHT-free ISA a reality. So you could enjoy tax-free growth and income during your life with the peace of mind no inheritance tax should be due on your death. Please remember though tax rules can change and benefits depend on circumstances. 

Which AIM ISA portfolio?

If you don’t have the time or inclination to research BPR-qualifying stocks and keep an eye on them to ensure they remain qualifying, you might consider a portfolio managed by a professional.

Octopus Investments manages the largest and longest established portfolio of this kind. 

What experienced investors could consider next

If you’ve been prudent enough to shelter significant amounts from tax in an ISA and your estate is likely to be liable for IHT, why lose the benefits at the end?

If you are doing an ISA this year and are worried about IHT, consider an IHT-free ISA. It could be the first step towards preventing the taxman from taking 40p of every £1 you’ve worked hard to save.  This is not advice or a personal recommendation to invest.

IHT rules at a glance

Until recently, if your total estate was worth more than the ‘nil-rate band’ (£325,000 for a single person), IHT of 40% could be due on the excess.

In April 2017 the new ‘main residence nil-rate band’ was introduced in addition. It starts at £100,000 and will increase by £25,000 a year until it reaches £175,000 in 2020.

So, single homeowners could pass on an extra £100,000 IHT free – £425,000 in total, rising to £500,000 by 2020.

When the new main residence doesn’t apply

1. If the property is not your ‘main residence’, i.e. second homes or investment properties
   
2. If you don’t have direct descendants
   
3. If your total estate is worth more than £2 million, in which case the main residence nil-rate band will be tapered and reduce to zero for estates worth £2,350,000 or more.

In addition, it is only transferable if you’re married or in a civil partnership – so together you could eventually shelter £1 million from IHT. Co-habiting couples and long-term partners cannot benefit.

Please note, this is only a short summary of very complex rules. Remember: tax rules can change and tax benefits depend on circumstances. If in doubt, please seek specialist advice.