Rich in ISAs? How this can aggravate your IHT liability and solutions to consider

For many UK investors, Individual Savings Accounts (ISAs) are a cornerstone of tax-efficient wealth accumulation. With their exemption from income tax and capital gains tax (CGT), ISAs offer a compelling shelter for long-term savings, and investors have an annual allowance of £20,000 per tax year.

There are several types of Individual Savings Accounts (ISAs) available in the UK, each designed to suit different financial goals and circumstances.

Here's a summary of the main types of ISA:

1.    Cash ISA 
This allows you to save money without paying income tax on the interest you earn. It works much like a regular savings account, but with the added benefit of tax-free interest.

2.    Stocks and Shares ISA
This allows you to invest in the stock market while enjoying tax-free returns. It’s designed for people who want to grow their wealth over the medium to long term and are comfortable with investment risk.

3.    Innovative Finance ISA
This allows you to earn tax-free interest by lending your money through peer-to-peer (P2P) lending platforms or investing in debt-based securities via a regulated online platform.

Are ISAs subject to Inheritance Tax (IHT)?

A common misconception persists that ISAs are protected from inheritance tax (IHT). Unfortunately, this is not the case. 

The value of your ISA is added to your estate and may be subject to 40% IHT on the portion of your estate above the nil-rate band (currently £325,000, plus any applicable residence nil-rate band).

Solutions to consider

Spousal Transfer via Additional Permitted Subscription (APS)

If ISAs are left to a spouse or civil partner, they can inherit the ISA wrapper through an APS, preserving the tax advantages. This is the simplest and most effective way to avoid IHT on ISA wealth—though it only defers the issue to the second death.

Gifting ISA Funds

You can withdraw funds from ISAs and gift them during your lifetime. These gifts may fall under the “Potentially Exempt Transfer” (PET) rules, becoming IHT-free if you survive seven years. However, this strategy sacrifices the ISA’s tax shelter, and you will no longer own the funds. 

Investing in AIM Shares within an ISA

Some Alternative Investment Market (AIM) shares qualify for Business Relief (BR), making them exempt from IHT after two years of ownership. These can be held within an ISA, combining tax-free growth with IHT mitigation. However, AIM shares carry higher investment risk and may not suit your own tolerance towards investment risk.  

Life Assurance to Cover IHT

A life Assurance policy written in trust can be used to cover the anticipated IHT liability on the value of the ISA. While this doesn’t reduce the liability, it ensures your beneficiaries receive the full value of the investment.

Spend from ISAs, Preserve Pensions

Pensions are outside the IHT net (at least until 2027), making them more efficient to pass on. Tax-free withdrawals can be taken from your ISA in retirement, while preserving your pension.

Conclusion: A holistic approach is Key

ISAs remain a powerful tool for tax-efficient investing, but it is important to consider their IHT implications in relation to an investor’s entire estate. By combining estate planning with investment strategy, investors can enjoy the benefits of ISAs during their lifetime while protecting their legacy for the next generation.

A financial adviser will assess your objectives and offer you comprehensive estate planning and investment advice, ensuring that your loved ones can inherit more of your wealth.

Although every effort has been made to ensure that the information provided in this article is accurate and correct, the information provided does not constitute any form of financial advice. We recommend that you take financial advice before making any financial decisions.