The merry widow - Inheritance tax “second death” planning for married couples

When you die, the vultures from HM Revenue and Customs begin to circle. Inheritance tax (“IHT”) is charged on the net value of your estate, after taking account of any debts at the time of your death. The first £285,000 is charged at 0% (this is known as the “Nil Rate Band”(“NRB”), and is scheduled to increase to £300,000 after 5 April 2007), and all the rest is taxed at 40%.   There are various reliefs from IHT for business property and for agricultural property, but any other assets you own when you die will be subject to IHT.   There is also an exemption for legacies left to your spouse (or civil partner). If you are married, and you leave all your estate to your spouse, there will be no IHT to pay when you die. When your spouse dies, however, IHT will be payable at 40% on their legacies to (for example) the children – except for their NRB of £285,000.   “Second death planning” is a basic IHT tax planning technique that effectively makes sure that the NRB of the first spouse to die is not wasted. Consider this:   Darby and Joan are comfortably off, with two children. In their Wills (drawn up by Darby on a form he bought at the local newsagent) they each leave their entire estate to the other, so they know there will be no IHT to pay when the first of them dies.   Their assets are:      

	Darby	Joan	Total
House (jointly owned)	200,000	200,000	400,000
Savings (Building Society joint account)	150,000	150,000	300,000
Buy to let property	125,000	Nil	125,000
Furniture, valuables, etc	25,000	40,000	65,000
Total	500,000	390,000	890,000

    If Darby dies first, leaving everything to Joan, there is no IHT to pay because of the “spouse exemption” described above, but when Joan goes, (assuming the values and the NRB are the same at the time), the NRB will be deducted from her estate of £890,000, and the balance of £605,000 will be liable to IHT at 40% - tax of £242,000 to pay, so the children will only get a legacy of £648,000.   If instead Darby and Joan had each left part of their estate equal to the NRB to a discretionary trust, then things would be different. When Darby died, there would be no IHT to pay (because the legacy to the discretionary trust was covered by the NRB, and the balance left to Joan was covered by the spouse exemption).   Joan’s estate is now worth £605,000, and there is also a discretionary trust (from which she and the children can benefit) worth £285,000. When Joan dies, the IHT payable is only £128,000 (£605,000 - £285,000 = £320,000 X 40% = £128,000), so the children’s legacy (including the value of the assets in the trust) is now £762,000 – they are £114,000 better off – which is, of course, due to Darby’s NRB having been used and not wasted (NRB = £285,000 X 40% = £114,000).   The key points to note about this type of planning are:  

• It can save up to £114,000 in IHT on the “second death”
• It only works for married couples (or civil partners)
• The survivor need not be worse off, because he/she can benefit from the discretionary trust set up on the death of the first spouse

  A wealthier couple could of course, leave the NRB legacy directly to the next generation (assuming the children are old enough and responsible enough to be trusted with £285,000), so this form of planning is particularly suitable in cases where:  

• The widow/widower would need access to all of the joint estate in order to maintain their standard of living, or
• The children are too young or too irresponsible to be trusted with a direct legacy

  It can also be useful where the main asset is the family home. The NRB can be left a share in the home, or possibly a cash legacy secured by a loan on the family home – see the February 2006 edition of Tax Insider for more details on this aspect.   A word of caution – this type of planning must be done by a professional – a solicitor or a tax consultant. There are several technicalities and pitfalls, and the drafting of the discretionary trust must be properly done – particularly since the 2006 Finance Act, which has put several obstacles in the way of this type of planning.