Are your ISAs (and PEPs) really tax efficient?

Your ISAs (and PEPs) are tax efficient - right?

Yes they are as far as income tax and capital gains tax are concerned. But will inheritance tax spoil the party?

A new study calculates that Gordon Brown stands to pocket a multi-million pound inheritance tax windfall from PEP (Personal Equity Plan) and ISA (Individual Savings Account) investors. Investors save tax now but are hit later when they die. Or more accurately their children are!

Investors were first allowed to put money into PEPs in 1987. ISAs replaced them in 1999, but existing PEPs have been allowed to continue. If an investor was far-sighted enough to have invested in the schemes in every year since 1987, and the portfolio had grown at the same rate as the average UK equity fund, it would be worth about £243,000 now.

On a portfolio of this size the investor, it is estimated, would have saved £10,247 in income tax over the past 18 years by investing through PEPs and ISAs. On the sale of the portfolio there would be a saving of an estimated further £20,000 of capital gains tax, making a total tax saving of £30,247. 

However, “the amount of tax saved during your lifetime can be dwarfed, by the size of the IHT bill.”

If we presume that a person’s worth already exceeds £275,000 (nil rate band 2005/2006), PEPs and ISAs are potentially subject to the full 40% tax. The IHT bill on a £243,000 portfolio would therefore be - brace yourself - £97,200.

Lifetime gifts are a good way of planning for IHT but it is well known that an investor cannot make a lifetime gift of an ISA/PEP, nor can trustees own a PEP/ISA.

So, are PEPs and ISAs still worth investing in?

The short answer is yes. There are some very powerful reasons in mitigation.  Indeed, ISAs and PEPs may possibly be used in IHT planning.

For example:

For many “younger” investors, IHT is not a consideration. The (income tax and capital gains tax) freedom of an investment far outweighs the potential for it to be treated as part of a taxable estate on death.

For many other investors, on death their assets will pass to a surviving spouse and because of the spouse exemption there will be no IHT.

On the investor’s death, the investment loses its PEP / ISA wrapper. The inheriting investor can then consider using those inherited investments in lifetime IHT planning by making lifetime gifts with no concern as to any capital gains tax arising on making a disposal if the disposal is made shortly after acquisition.

For married couples, holdings of PEPs / ISAs can be very suitable investments to be left to a discretionary will trust on the first death.  The use of a will trust enables the first to die to use his or her nil rate band (so saving IHT on the second death) yet also enables the surviving spouse to maintain financial security by the trustees making payments of benefits to him / her from time to time. Of course, on the first death the PEPs / ISAs lose their tax efficient status.

The Key Consideration

In these circumstances, far from being a burden, a holding of PEPs / ISAs can be a positive advantage in IHT planning. They also produce very good income tax savings, particularly for higher rate taxpayers, and capital gains tax savings.

As ever, planning here is should be just one part of your overall personal strategy, to ensure you achieve your objectives in life.