How to use your Isa to reduce your inheritance tax bill

Older man in cafe looking at an iPad/tablet
Should those nearing retirement spend their Isas or their pensions first? Credit:  Tara Moore

For most individuals the plan is to arrive at their retirement date with a healthy pension pot and considerable savings in their Isa accounts. But how should these investors juggle the two pots of money? Should one account be drawn down before the other?

The overhaul of the pensions system with the launch of “pension freedoms” has changed how this balance works. The pension freedoms mean that individuals no longer have to buy an annuity with their pension money at retirement.

Instead they can keep their money invested and draw an income from it. More attractive still is the fact that pension assets can be passed on after death free of inheritance tax. This is not the case with Isa assets.

This means that how Isa savings are used is even more important. Research from MetLife, the insurer, found that 28pc of those over the age of 55 are planning to rely on their Isas in retirement.

“Isas can continue to work for investors well into retirement. My main advice, whatever your age, is to keep a long-term view and keep assets growing. If you’re in early retirement, remember you could live to 100,” said Michelle McGrade, of TD Direct Investing, the fund shop.

When making investment decisions, she advised individuals to think of their Isa pot in two phases: from age 55 to 75, and over the age of 75.

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For the first phase investors should focus on building the portfolio, investing in assets that will grow over the 20 years and not dramatically reduce the risk in the portfolio. For the 75+ phase you may want to switch the investments to lower risk assets, and to focus them more on income-generating funds, stocks or bonds, to help supplement other income.

Phillippa Gee, of Philippa Gee Wealth Management, the adviser firm, said that with the annual Isa limit rising to £20,000 from next month, people could have substantial sums stashed away in Isas in the future.

She also cautions on the amount of risk taken between pension savings and Isa investments. “People used to have their pension annuity as a low-risk income and then invest their Isas more aggressively, however, with the pension usually now involving risk, it seems sensible to limit the risk you are taking,” she said.

However, there are downsides to Isas in retirement. A big one is the fact that Isas are not as inheritable as pensions. Ms Gee said that this is an issue that may change in the near future, but until that point Isas can only be passed on to a spouse and not to children, grandchildren or other friends or family members.

The ability to pass on to spouses is a relatively new feature, introduced two years ago. “Previously, the tax-wrapper passed away with its owner and money that had been sheltered became liable for income and capital gains tax thereafter,” said Tom Stevenson, investment director at Fidelity, the fund shop. Be warned, this does not apply if a couple is living together but not married.

The process of passing these assets on to a partner is relatively complex, but essentially the surviving spouse gets a one-off Isa allowance equivalent to the amount they inherited. This is called an “additional permitted subscription” and can be used once the death has been registered with the Isa provider or providers.

Isas are also counted as part of the estate when it is assessed for inheritance tax purposes, where pensions are not.

For pensions the full value can be passed to a beneficiary inheritance tax-free, provided the pension-holder dies before the age of 75. If they die after age 75, the pension can still be bequeathed tax-free but the beneficiary will pay tax on income taken at their marginal rate of tax or up to 45pc if they take a lump sum.

 

 

 

The other downside is that the money held in an Isa account is considered when assets are assessed for means-tested benefits or for care home fees. This not the case with pensions.

Alistair Cunningham, of Wingate Financial Planning, an advice firm, said the rules are a “bit archaic”, but for now it is more advantageous to keep larger sums in pensions than in Isas when you reach the later stages of retirement, when you may need care.

For all these reasons Mr Cunningham said that “the general rule of thumb is to spend the Isa before the pension”. There are also tax advantages to taking money out of Isas as income — as you do not pay income tax on the cash.

“Money paid into Isas can be accessed at any time and, unlike with pensions, you can withdraw as much as you like without tax implications.

“This can be incredibly useful if you have any large expenditures that need to be covered before you reach retirement age or if you have already used your 25pc tax-free lump sum from your pension,” said Mr Stevenson.