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The ISA (Individual Savings Account) is a very tax-efficient tool to include in an investor’s arsenal. Yet one area where it falls short of a pension pot is that the former is typically liable to inheritance tax (IHT) at 40% upon the owner’s death. By contrast, a pension pot can be passed down to beneficiaries completely free of IHT in 2023-24 – making it a valuable tool not only for retirement planning but also for estate planning.
However, there is one unique way to shield some (or even all) of your ISA investments from IHT. This involves holding Alternative Investment Market (AIM) shares which qualify for Business Relief. Below, we explain how this works in more detail, offering ideas to help investors plan their portfolios and estates with a financial adviser.
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The tax profile of ISAs
Each tax year, a UK taxpayer can contribute up to £20,000 to all of his/her ISAs. For instance, an investor might put £10,000 into a Stocks & Shares ISA, £5,000 into a Cash ISA, £2,500 into a Lifetime ISA (also called a “LISA”) and £2,500 into an Innovative Finance ISA. Any capital gains, interest and dividends earned within these accounts will be free of their respective taxes.
However, investments held in your ISA(s) – whether cash, equities, bonds or other assets – are not automatically free of inheritance tax (IHT) when you die, like a pension pot. In 2023-24, IHT is usually levied at 40% on the value of an individual’s estate once it exceeds £325,000.
Certain rules can “extend” this IHT-free allowance such as the Residence Nil Rate Band, which lets the owners pass down an additional £175,000 to “direct descendants” if the estate includes the family home. However, an individual may still need to pay IHT on investments held in an ISA if the total estate is valued at over £500,000 after his or her death.
How AIM shares can help
Sometimes, an investor can invest in AIM shares via an ISA. These might qualify for Business Relief, which can let the investor claim 50% or 100% IHT relief on the value of certain assets depending on their nature and purpose.
For instance, shares in an unlisted company – such as specific AIM companies – might qualify for 100% relief. Conversely, an investor who directly controls (or is a partner in) a business which owns land, buildings or machinery, then these assets could qualify for 50% Business Relief. Regardless, the asset owner must have held it for at least two years before their death in order to qualify for the relief.
This rule could have important estate planning implications for investors who are considering how to best pass down their wealth to loved ones. For instance, perhaps an investor owns a large non-AIM portfolio with his ISAs and wants to make the portfolio more IHT efficient. By selling certain shares, he could gradually reinvest the money into AIM shares.
Other IHT planning options for investors
Investing in AIM shares which qualify for Business Relief can be a powerful tax planning strategy. Yet it may not suit the goals, preferences and financial plans of all investors. Companies listed on the AIM stock exchange are typically less regulated and are widely seen as “higher risk” compared to publicly traded stocks. Therefore, the risk levels involved may not suit investors with a more cautious approach.
By contrast, AIM shares may not be “adventurous” enough for other investors who are more comfortable with risk and are looking to generate high returns from small businesses with high growth potential. Investors looking to invest in startups, for instance, may want to consider other tax-efficient investment options such as the Seed Enterprise Investment Scheme (SEIS). Here, a business can hold no more than £350,000 in gross assets its investors can claim 50% tax relief on SEIS investments up to £200,000 per year. Capital gains are exempt from tax and SEIS shares are free from IHT if held by the investor for at least two years.
Another alternative to investing in AIM shares in an ISA are companies which qualify for the Enterprise Investment Scheme (EIS). Here, an investor has even more investment scope than EIS, with an annual £1m cap on companies which qualify (or £2m if they are classed as “knowledge intensive”). Similarly to SEIS, EIS shares held for at least 2 years are exempt from IHT. The two schemes are arguably superior to AIM shares in an ISA due to unique features such as the “loss relief” mechanism. Here, an investor can claim back the value of their original EIS/SEIS investment, if it fails or is sold at a loss, equivalent to the investor’s highest marginal rate (e.g. 45% for an Additional Rate taxpayer).
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