As we all know, Inheritance Tax takes away from the sum you inherit on the unfortunate passing of a loved one.
There are some methods to limit the amount of tax you’re dealt, and today, we’re going to talk about the appropriately dubbed inheritance ‘Generation Skipping’
Read through our guide on why you would skip a generation, and how this can save you money.
(Read Time: Approx. 5 minutes)
Topics Discussed:
- Discussing methods to help to reduce the tax liability of wealth being passed through generations.
- Finding out the basics of Inheritance Tax and how it can affect your saved wealth, and its distribution.
What is ‘Generation Skipping’?
Nowadays, people don’t tend to be as reliant on their parent’s wealth being passed down.
This opens the doors for a new method of cleverly subverting the amount of Inheritance Tax which you are subject to, when passing down wealth from generation to generation.
The method is simple, yet effective; by skipping a generation of family to pass wealth down through, the amount of Inheritance Tax taken is lowered.
This is due to Inheritance Tax being applied with every time wealth is passed down a generation, and so by passing only once instead of twice, the taxable amount is lowered.
An Example of ‘Generation Skipping’
Let’s take an example family; we’ll call them the O’Tinga family.
Great-Grandfather O’Tinga has amassed £100,000 to pass down to his immediately family.
Upon his unfortunate passing, Great-Grandfather O’Tinga passes down his £100,000 to Grandfather O’Tinga.
Assuming that the Inheritance Tax rate is 40% and remains at this (for the benefit of this example), this means that £40,000 of this inheritance is taxed by the government. And thus, Grandfather O’Tinga receives £60,000 from the inheritance given by his father.
Unfortunately, time comes for Grandfather O’Tinga, and he leaves his saved-up £60,000 for his daughter, Mother O’Tinga. This is once again hit by Inheritance Tax, and 40%, or £24,000, is taken by the government. This leaves Mother £36,000.
So far, the government have taken a sizeable bite out of this generational wealth. But that’s not the end of it.
In the years to come, when it is time for Mother O’Tinga to move on from this world, she leaves the saved up £36,000 to her daughter, Miss O’Tinga. The government once again, take their inheritance tax charge. This takes £14,400 from the £36,000, leaving £21,600.
So, this saved sum of money from 4 generations is taxed over three-quarters of its original amount. HMRC have taken a sizeable bite of this wealth, to the tune of £78,400.
Let’s instead consider utilising generation skipping. We’ll take the O’Tinga’s back into account, and travel back to Miss O’Tinga, Mother, and Grandfather.
Mother O’Tinga has fallen on hard times, but luckily her Father has amassed some wealth in his lifetime, which he now has spare. So, upon his death, the obvious answer would be to leave the entire £250,000 which Grandfather O’Tinga has saved to his daughter.
But instead, he cleverly leaves this to his Granddaughter, Miss O’Tinga. This allows for Miss O’Tinga to loan some of the money to her Mother, as well as keep and invest some.
This means that the £250,000 is only trimmed by the shears of HMRC once; thus taking 40% of the £250k, and not also taking 40% of that.
Variations on “Generation Skipping”
Whilst taking this method at face value works well, there are other methods in inheritance with “Generation Skipping”.
Arguably more common than this method, we have Wills which are varied.
Typically, the older generation will have a Will stating that once they pass, they pass down their fortune to the generation below. This is also followed up by the will stating if that generation is to pass, the generation below that instead inherits the money.
This is as Wills are typically laid out. But let’s say that the middle generation, the ones inheriting the money, have done alright for themselves, and don’t need the money.
It would be sensible in this situation to instead execute a variation of the will, leaving the money directly to the youngest, or third generation.
This is what the purpose of a varied will is. It allows the executors of the will to modify the will in accordance with the original bearer’s vision, and benefit from skipping a generation’s worth of Inheritance Tax.
And thus, the true power of the “Generation Skipping” is showcased. In the examples above, we demonstrate how much money a will can take, and how much money a simple generational “skip” can save. Even one generational skip can save as much as 24% of the value of the wealth left behind.
Whilst these two different methods are simple, there is a third, more complex, and potentially more effective method.
The role of Trusts in “Generation Skipping”
Utilising a Trust is far more complex, but far more practical than typical wills. When considering whether to make use of a Trust, read through the advantages and disadvantages carefully.
A trust is, in the simplest terms, an arrangement wherein money is held by an organisation on behalf of several members of a family (although it is not limited to family). The trustees, appointed by the creator of the trust, are given full discretion over the held money in the trust.
Typically, in a Will, a couple can state that instead of their children receiving their wealth, their trust is instead given this money, and their own parents, as well as children (and a remote issuer) are given the roles of Trustee. The first Inheritance Tax is charged on their wealth upon their unfortunate passing, but a second, or potentially third, is not.
Trusts can last up to 120 years. This could potentially mean this money is stored for 4 generations worth of one family.
But the Taxman was privy to this idea, and thus created a periodical charge to make up for the lack of Inheritance Tax. This adds up to around 6% every 10 years and covers up to the available nil rate band (which is currently set at £325,000 until 2028).
So, a Trust isn’t a perfect workaround to Inheritance Tax, but it works out better depending on the time between generations. If we allow a generation to be 33.33 years, this works out as around a 20% tax charge for each generation, halving the effective amount of tax you’d pay.
This works out to be more tax overall as skipping a whole generation. So, trusts are in some ways better, if you’re looking to award each generation with a sum of the wealth, but not absolutely better.
Concluding Thoughts
Overall, whilst Inheritance Tax is always going to be present when passing down generational wealth, there are some methods to sidestep some of the brunt of the charges
Regarding minimising tax on your Inheritance, Generation Skipping and Trusts are two good examples of some methods to do it, but for a full and complete understanding, you should get in touch with www.taxexpert.co.uk, to find the most tax-efficient methods of passing down to your loved ones.
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Ilyas Patel