The Tories would let you pass on £2m tax-free but political tinkering has left many families confused

The Conservative party would allow families to pass on up to £2m of assets free of inheritance tax (IHT) if it were elected, it emerged last week.

It had already announced that it would raise the inheritance-tax allowance to £1m, and last week it confirmed that it would allow married couples to transfer this to their spouse on death — thereby in effect doubling the survivor’s threshold to £2m.

That is more than three times the present £624,000 allowance for spouses — raised from only £300,000 last year and due to be lifted to £700,000 by 2010.

Increasing the IHT threshold to £1m would enable about 9m families to escape the unpopular 40% tax, and pushing it up to £2m would enable even more to pass on their assets without charge.

A Conservative party spokesman said: “We would keep the automatic transferability of the nil-rate band, if it is still in place when we are elected, and we would raise the nil-rate band to £1m per person. This has always been our position — it’s just that we haven’t shouted about it.”

Fewer than 50,000 estates were liable for IHT in the financial year 2007-8.

The ability to transfer your IHT allowance to your spouse, whether under the Conservatives or Labour, brings into question the need for the trusts still being marketed by accountants and financial advisers. They can be expensive to set up and, with the doubling of the allowance, may be unnecessary for many families. We answer your questions.

How does the transfer of an IHT allowance to a surviving spouse work?

The ability to transfer your IHT-free allowance to a surviving spouse on death is what has pushed the Conservatives’ threshold to £2m and the Labour limit to £624,000.

However, many people are confused about how this works, while recent figures from Zurich Financial Services show that only one in three people is aware of the changes that have raised the IHT bar.

Under rules introduced in the pre-budget statement last year, married couples and civil partners can transfer the unused part of their IHT nil-rate band — the value of the estate not subject to IHT, now £312,000 — to their surviving spouse or civil partner when they die.

To make the transfer, however, widows and widowers must have the necessary paperwork to prove that the deceased spouse did not use the IHT allowance in his or her own right.

Say a father on his deathbed gave his children £125,000 five years ago. At the time the IHT allowance was £250,000, meaning that there was no immediate inheritance tax to pay but he used up half of his allowance.

If the mother died today the family could use her IHT allowance and half of his at today’s levels, rather than at the time of his death. In other words, £312,000 plus £156,000 would be exempt from IHT.

So what trusts are still being sold?

Before the pre-budget changes, married couples had to set up discretionary will trusts to transfer their unused allowance to their spouse on the first death. However, the government’s move has made them largely redundant for tax purposes, unless you have assets worth more than £624,000. The Tory proposals would make them useful for even fewer families. However, tax is not the only reason to set up a trust.

So why might I need a trust?

Trusts are a great way to protect assets and make sure your money goes to the right beneficiaries.

Suppose you were worried that your grandchildren might inherit money too young. As its name suggests, a discretionary will trust gives the trustees complete control over when the beneficiaries inherit. You could write a “letter of wishes” alongside your will to inform the trustees that your grandchildren should come into your money only at, say, 18 and they would act in accordance.

Discretionary will trusts are also useful if you fear your grandchildren could be disinherited by a second marriage.

Finally, trusts give you flexibility. John Wray of law firm Wedlake Bell said: “You never know what governments are going to do with tax. Trusts can be dismantled within two years of the first death, which gives the surviving spouse the flexibility to decide what to do based on the tax rules at the time.”

I already have a trust. What should I do?

You may be marginally better off, tax wise, transferring your allowance under the government’s new rules, rather than through your trust. This is because the trust transfers the allowance at the time of the first death, whereas the government’s rules allow you to use up the unused portion of the spouse’s allowance at the time of the second death when it is likely to be greater.

However, if family considerations are more important to you than the tax benefit, it might still be worth keeping it — especially as you have two years to change your mind after the first death.

Published in The Sunday Times, 7 September 2008