ISAs and the complicated case of inheritance tax
As the returns generated from ISAs are free of capital gains and income tax, they are commonly used for the purpose of building up a retirement fund. However there is no protection against inheritance tax, which means 40% of the funds held within the ISA could be handed to the government on death. It is therefore important to fully understand how savings and other wealth can be used in retirement, while maximising the benefits for the next generation.
Although the surviving spouse does not automatically inherit their deceased spouse’s ISA – it is distributed in accordance to their Will, or intestacy if a Will does not exist – any funds that are left to the surviving spouse are free of inheritance tax. As stated above, any funds that are inherited by an individual who is not a surviving spouse could be subject to inheritance tax if the value of the funds surpass the deceased’s remaining nil rate band.
On a more positive note, irrespective of who is to inherit the ISA the surviving spouse can still apply for Additional Permitted Subscription (APS). This gives them an increased ISA allowance equal to their deceased spouse’s ISA funds at the date of death, which can be utilised with their own capital.
The surviving spouse can either register the APS with the deceased spouse’s ISA manager or with an ISA manager of their own choice. Additionally, the type of ISA used by the deceased does not have to match the ISA for which the APS is being applied to, i.e an APS from a deceased’s Cash ISA can be applied to Stock and Shares ISA in the survivor’s name. It is also possible to have multiple APS’ with different providers, resulting in an APS for each ISA. However, it should be noted that once the APS is assigned to an ISA, only that particular ISA can receive the increased subscriptions.
It is possible for the surviving spouse to spread the APS over three years starting from the date of death, which is helpful if they have insufficient liquid assets to utilise the entire APS in one go.
It is important to remember that the ISA wrapper – along with its capital gains and income tax exemptions – will disappear on the death of the owner, and the APS is equal to the value of the ISA on the date of death. Therefore any investment growth between the date of death and the utilisation of the APS will not be permitted to be contributed into an ISA if the surviving spouse has already utilised their annual ISA allowance, and will therefore be subject to capital gains and income tax. However, the intention of the government is to introduce legislation that will make income and capital gains generated from an ISA of the deceased tax-exempt during the administration of the estate. This is due to come into effect on 6 April 2018.
For the purpose of maximising the tax efficiency of your retirement planning, it should be noted that although an ISA of the deceased will not be subject to inheritance tax if left to the surviving spouse (thanks to the spousal exemption rules for inheritance tax), it will eventually be subject to inheritance tax on the second death. It is therefore usually wise to use the funds in your ISAs before using your pension fund to fund retirement since any funds remaining within the pension will escape inheritance tax regardless of who will inherit the pension.