Inheritance tax in UK

The inheritance tax system is getting more complicated.

Each person may bequeath £325,000 tax-free and married couples can pass this allowance on to their spouse at death, giving a combined £650,000 per couple.

In addition to this a new allowance called the “main residence nil-rate band” is being phased in from this tax year, giving an extra £100,000 per person that applies to the family home only – and only where it is bequeathed to a “direct descendant” such as a child or grandchild. Above these allowances inheritance tax of 40pc applies.

A valuable additional perk is that where money or other assets are given while the owner is alive, these gifts can fall outside the estate for inheritance tax purposes provided that the giver (technically called the “donor”) survives for seven years after making the gift.

This is what gives rise to the tax planning opportunity offered by equity release. If 40pc tax is going to be payable on some of your estate at your death, could you juggle things with the help of a mortgage so as to reduce the amount of tax paid?

Getting to grips with compound interest

Most equity release plans work by allowing interest to roll up over the course of the loan.

Borrowers don’t make repayments as they go, so the interest compounds. In some cases borrowers pay the interest and thus keep overall costs low but for now this is uncommon.

The danger is thus that if the borrower lives for longer than expected, the debt can mount and erase any potential death duty saving.

Say you have a home worth £1.5m. Aged 80, you take out a £200,000 equity release mortgage with a fixed rate of 4.2pc compound. You give the money to a child.

After seven years the interest bill will have reached £68,200. That is the point at which the gift to your child falls outside your estate.

Had you not undertaken the equity release, that £200,000 would have been subject to 40pc tax – a liability of £80,000. So at that point the sums work in favour of the mortgage, and you have effectively saved about £12,000 in tax.

If you survive 15 years, however, and die aged 95, your debt will have mushroomed to £375,100. Here the mortgage route will have proved far more costly: you will effectively have paid £175,100 interest to be spared £80,000 tax.

The figures show how rapidly interest can compound. So, where younger borrowers are concerned or where there is not a potential tax saving to be made, it might still be wiser to consider raising money by downsizing to a smaller property where possible. Other means of reducing interest costs, such as paying the interest as you go (or asking your child to help do so), should also be considered.

Why it’s not all about tax

In the example above the parent who lives to 95 ends up accruing more interest than they save in death duties. But, of course, there is also the benefit the child has had of the £200,000 gift for 15 years. And that may have a value not measured in pounds and pence.