How equity release can reduce your inheritance tax bill

Equity release is regularly used to allow individuals to access capital locked in their properties to help fund their income in retirement.  It can also be used to reduce your inheritance tax bill which is what this article focuses on. 

With substantial increases in UK house prices over the years, it is inevitable that people have built up significant wealth in their properties. Despite house prices now cooling, property wealth grew 8% year on year to reach £5.6 trillion by the end of 2022.  As a result, many people will have large inheritance tax bills looming over their estates.*

A recent Wealth Report from M&G stated that future generations are expected to inherit more than £293bn, with wealth passed to younger generations projected to double over the next 20 years – and could reach as much as £5.5trillion by 2047 – with individuals born after the 1980s receiving £200,000-£400,000. Added to this, following changes to pensions legislation in 2015, pension funds are technically outside of an estate for inheritance tax purposes. Therefore, they can potentially be passed down generation to generation in a very tax efficient manner. For those with large pension savings, it may be sensible to reduce or stop taking cash flow from the pension fund and instead release some equity from their property for cash flow purposes. 

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Establishing your estate plan

There are several different ways you can pass down your wealth, known as estate planning, including for those individuals with significant wealth tied up in their properties. More often than not estate planning is driven by a desire to maximise the wealth that can be passed down to loved ones, however, personal financial security should be your number one priority before considering how best to pass down your estate. Once this has been established, it is possible to identify which assets, such as property, are available to meet your estate planning objectives. 

Releasing some of the equity from your property isn’t just a solution for those needing some extra capital or cashflow. This can also be used as a tool for estate planning purposes. A lifetime mortgage and gifting arrangement allows people to reduce the value of their estate that maybe subject to inheritance tax, so that more of their hard-earned assets can pass tax efficiently to the next generation. It also means that liquid assets, such as cash and savings, remain untouched and are available to fund expenditure for the remainder of their lifetime.  

Of course it is important to consider your overall financial situation and equity release may not be suitable for everyone.  By not servicing the interest on an equity release arrangement, the interest will compound which can be significant over time. Taking out an equity release arrangement could also potentially result in you losing means tested local authority benefits. 

What is a Lifetime Mortgage?

A common form of equity release is through a Lifetime Mortgage, which is available for homeowners aged 55 and over. A Lifetime Mortgage enables you to borrow money secured against the value of your property. Unlike a conventional mortgage, you don’t have to pay the interest during your lifetime, instead the interest on your loan is ‘rolled up’ and it compounds each month or every year depending on which plan is used.  This means that the amount you owe on your Lifetime Mortgage grows every year.  The outstanding balance is typically only repaid on death or permanent move into a care home. Importantly you remain the legal owner of the property and will benefit from any increase in the property value over time. 

One way of passing on wealth during your lifetime could be to release equity from your property and make gifts to your loved ones. In a recent case, we helped a gentlemen use a lifetime mortgage to release and gift £3million to his children and grandchildren. His property was valued at £9million and therefore the potential inheritance tax bill saving here is over £1.2million, provided he lives for 7 years from the date at which the gift was made.  

Additionally, the fixed interest that accrues on the loan will be a debt on his estate and will reduce the value of his estate further for the purpose of inheritance tax. It is worth noting that the amount of interest charged, along with potential fees linked to the arrangement of a Lifetime Mortgage can vary depending upon individual circumstances, therefore it is important to seek professional advice before entering into this type of arrangement. Also, there will in fact be an inheritance tax saving after 3 years from the money being gifted due to taper relief.  

If you die within 7 years of giving a gift and there's inheritance tax to pay, the amount of tax due depends on when you gave the gift. Gifts given in the 3 years before your death over and above your nil rate inheritance tax band are taxed at 40%. Gifts given 3 to 7 years before your death over and above your nil rate inheritance tax band are taxed on a sliding scale known as 'taper relief'. 

Now not everyone will be sitting on property wealth of £9m but it does show you the way at which those with larger estates can actually save money using equity release. A concept that many may not have even thought of. 

How the freeze on allowances will hit home

The current inheritance nil rate band (the level at which you can pass down wealth free of inheritance tax) of £325,000 per individual and residence nil rate band (the amount over your nil rate band that can be added when passing down your main residence to direct decedents) of £175,000 per individual will be frozen until at least April 2028.  These allowances were previously frozen until April 2026. 

The increase to house prices along with the frozen inheritance tax allowances will see a rise in those being hit with an inheritance tax bill, especially those with significant property wealth who’s will likely add thousands of pounds more to their tax bill. Furthermore, for individuals with a net estate over £2m the residence nil rate band is tapered by £1 for every £2 over this threshold. Estates (based on a married couple if an allowance isn't used on first death) with a net value of £2.7m will completely lose any benefit of the residence nil rate band allowance. This is where an equity release and gifting solution could reduce the value of a net estate below the £2m threshold and reinstate their residence nil rate band, potentially saving thousands of pounds in tax. 

What are the benefits and safeguarding features of using equity release?

The lifetime mortgage market has changed dramatically over the past decade, and many providers have introduced attractive benefits and safeguarding features on the products they offer. These include: 

  • Interest rates which are fixed for life.  
  • Lump sum with reserve facility – you can choose between having an initial lump sum only or you can have an initial lump sum plus a reserve facility.  You only pay interest on the initial lump sum. The reserve facility allows you easy access to further funds in the future and you don’t pay any interest on the monies in the reserve facility until you draw them down. 
  • No negative equity guarantee - you and your beneficiaries will never owe more than your home’s worth. 
  • Porting – if you decide to move home in the future, your Lifetime Mortgage can be transferred or ported to your new property, providing it meets the lender’s lending criteria; 
  • Downsizing protection – if you need to move to a smaller property in the future, you can repay your loan without facing any early repayment charges if your new home does not continue to meet your plan’s criteria. 
  • Partial capital repayments – you can repay up to 10% of the original loan amount every year if you wish to do so with no early repayment charge. 
  • Fixed early repayment charges – so you know how much you will be charged should you choose to pay off the loan early, subject to the provider's T&C's.

What are the downsides of using equity release?

  • The initial release will increase if the interest is not serviced and be rolled up which means the amount you owe on your Lifetime Mortgage grows every year. 
  • Choosing equity release may affect you in the longer term.  You need to be sure that the arrangement suits you both now and in the future.  For example, equity release can make it hard to move, if you decide you want to downsize later on you may not have enough equity in your home to do this. 
  • Interest rates on Lifetime Mortgages are generally higher than on traditional residential mortgages. 
  • Releasing equity from your home may affect your eligibility for state benefits, grants or allowances. 
  • If you release too much equity from your home you may find you do not have the money you need later in your retirement, for instance if you need to pay for long term care. 
  • There may be substantial early repayment charges if you decide to voluntarily repay the monies released typically within 8 to 15 years of taking out a Lifetime Mortgage. 

How we can help

The Private Office has specialist advisers for equity release.  Importantly these advisers are also Chartered Financial Planners so have expertise across all areas of financial planning which makes them well positioned to consider your overall financial situation and provide the most suitable solutions to meet your objectives. 

There are lots of other ways that you can reduce your inheritance tax bill which the advisers at TPO are knowledgeable on and will explore with you the most suitable solutions for you and your family. 

If an equity release is considered suitable, as an independent financial adviser firm, The Private Office, has the freedom to explore the whole of the equity release market and the advisers have excellent knowledge of the products available. If you’d like to arrange a free no obligation initial consultation, please get in touch.

In our latest webinar The Art of Avoiding Inheritance Tax, experts Steffan Alemanno and Harry Donoghue showcase the steps you can take to pass down your wealth in the most tax efficient way. Watch it back here! 

*Source: Equity release council

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This article is for information only and does not constitute individual advice. 

Please note: that the Financial Conduct Authority (FCA) does not regulate estate planning, tax or trust advice. This is a lifetime mortgage. To understand the features and risks, ask for a personalised illustration.