My wife and I have had cash ISAs since they were introduced, happy with the promise of tax-free returns on our savings. However, we were recently at a party and someone mentioned that ISAs form part of your estate when you die for inheritance tax, which surprised us as we thought ISAs were tax-free. Is this true and, if so, is there anything we can do to correct this?
- Tom Conner
Thank you for your interesting question on avoiding inheritance tax on ISAs.
It is true that individual savings accounts (ISAs), both the cash and stocks and shares varieties, have long been marketed as tax-free savings and investments accounts, allowing individuals to make a return free of income tax or capital gains tax.
However, I’m afraid your acquaintance was right in that ISAs are not free of all tax: they are indeed added to your estate for inheritance tax (IHT) purposes.
You and your wife currently have cash ISAs, but a new piece of legislation has just been introduced that allows you to hold AIM-listed shares (AIM stands for Alternative Investment Market, which is a sub-market of the London Stock Exchange specifically designed so that smaller companies can float shares) within the wrapper of ISA.
Providing you’re willing and able to take on investment risk, you could escape IHT liability on the contents of your existing cash ISAs by converting them into an AIM portfolio, as the majority of AIM stocks qualify for business property relief (BPR) for IHT purposes.
The Risks of Holding AIM Shares in Your ISA…
However, this is not a foolproof strategy. Share prices are volatile by nature, and there’s the very real risk that a portfolio of AIM shares held in an ISA could incur losses that exceed any IHT savings.
You won’t have the current security you have with cash on hand and, moreover, not all AIM stocks qualify for an IHT exemption — companies that deal in securities, stocks and shares, land or commercial buildings or which are dedicated to making or holding investments are likely to be barred from business property relief (BPR), for example. There’s also no definitive list of AIM stocks that will qualify.
So while it is technically possible to mitigate your IHT liability on ISAs providing you understand and are willing to accept that the sum you have invested could go down as well as up, these potential pitfalls mean that the best way to approach the issue is via a professional portfolio manager who specialises in AIM-listed stocks and who today run IHT-free ISAs.
Inheriting a Spouse or Civil Partner’s ISA Allowance…
It’s also worth mentioning that although the balance of an ISA will be added to the rest of your estate on death and taxed accordingly if your total estate as a single individual exceeds £325,000, you can inherit a spouse / civil partner’s ISA allowance on their death.
Essentially, this gives you an extra ISA allowance to use on top of your yearly limit (£20,000 in the 2019/20 tax year).
How Much is the Inherited ISA Allowance?
This depends on when your partner passes away as it will be affected by the legislation change. If your partner died on or before April 5th 2018, your inherited ISA allowance will be the value of your partner’s ISA(s) at the date of death.
So if they had £50,000 in an ISA or ISAs, you’d be able to invest £50,000 tax-free into an ISA in addition to your ISA allowance for that year.
If your partner died on or after April 6th 2018 then you can can either:
- Inherit the value of your partner’s ISA(s) at the date of death and have this as your additional ISA allowance
- If your partner’s ISA(s) remains open and continues to earn interest, you can inherit an ISA allowance that is the value of your partner’s ISA(s) at account closure. Your partner’s ISA(s) can remain open up to the third anniversary of their date of death.
You will be able to use the higher of the two values as your inherited ISA allowance.
The exception to this is if your partner died on / after April 6th 2018 and you start using this allowance before your partner’s account or accounts are closed. When this happens, you will inherit an ISA allowance that is the value of your partner’s ISA(s) at date of death.