Important Information: please keep in mind that the value of investments can go down as well as up, so you may get back less than you invest.
RECENT research from Fidelity International has revealed just how many of us expect to receive an inheritance or family gift as part of our long-term financial plans.
In polling, two-fifths (43%) of people said they expected to receive an inheritance or lifetime gift of wealth from family and friends in the next five years. That amounts to a huge transfer of wealth between generations because the average inheritance received in the last five years currently stands at £70,639, with lifetime gifts amounting to £58,439.1
Does an inheritance feature in your financial plans? If it does, you may be faced with a host of decisions about how best to use that money to secure your own financial future, and that of those you plan to pass money to as well.
With the help of Fidelity’s financial advice specialists, we’ve pulled together some of the key considerations for those who inherit. Remember, what’s best for you depends entirely on your own circumstances and there is no one-size-fits all solution.
If you think you may need assistance working out the best use of your inheritance, an authorised financial adviser may be able to help.
What should I do with an inheritance?
Many of us dream of the day when we no longer owe anything to anyone - be it a mortgage, bank loan, student loans or credit card debt. That might prompt those receiving a significant sum as an inheritance or gift to immediately clear as much debt as they can - but is that always the best thing to do?
Not all debt is the same. A key feature of any debt is the interest rate and maintaining high-cost debt - which is more likely to come in the form of credit cards or bank loans - is likely to mean you are paying a significant amount towards interest. It might make sense to clear that debt to limit the amounts you’ll have to repay in the long-term.
Other debt will come with a lower interest rate, including mortgages. Here, the interest may be set at levels which add far less to your burden and it could make sense to maintain that debt and use inherited money for other purposes, including investing it for the future.
Student loans work differently. There is an interest rate, but there are also rules which link the amount you repay to the amounts you earn in income. These mean it may not make sense to clear the balance on student loans and could even mean you end up paying more in the long-run.
If you invest - where’s best?
Fidelity International’s research suggests that almost a third (32%) of those who have or are expecting to inherit money use it for their own long-term investing as savings or towards their pension.2 That can make a lot of sense but there are still decisions to make about where the best home for that money is. Always bear in mind that investments can fall in value, too.
A reliable rule for investing is that it should be done as tax-efficiently as possible. UK taxpayers typically have access to pensions and ISAs, both come with rules about how much you can pay in, the tax you pay when you withdraw and when you can access your money. Check the full rules for ISAs and pensions for yourself.
For ISAs, we can each typically pay in £20,000 a year into an ISA with no tax to pay on any investment gains we make. You can withdraw your money whenever you wish, which makes ISAs a valuable tool for money that you believe you may need access to.
Pensions allow you to pay in 100% of your earnings up to a maximum annual allowance of £40,000, and there is also an overall Lifetime Allowance governing how much can be held inside pensions in total - currently set at £1,073,100 - and what you contribute benefits from tax-relief. Any investment gains inside a pension are free of tax. Current rules mean you can access your pension money from age 55 (this may change to 57 in 2028) and, at that point, you are able to withdraw as much as 25% of it tax-free. The rest is taxed at whatever rate of income tax you pay.
Because you can’t access your money whenever you like, pensions are suitable only for money you are happy to lock way until you reach the age when withdrawals are allowed.
Will you need an income?
Investments have the potential to make a return in different ways. As well as growing - or falling - in value, some shares or funds will naturally produce regular income, via company dividends for example, that flow to you. You typically have the option of taking this as income or reinvesting it to build a higher total overall.
If you need a cashflow from your investments you can take this natural income as it is produced but, if your money is held outside of an ISA, there may be tax to pay if it exceeds the £2,000 of dividend income that tax rules allow. It might make more sense to instead reinvest this naturally produced income and then take periodic withdrawals from the total, with Capital Gains Tax (CGT) liable on any gains you have made.
We each have an allowance of £12,300 that can be taken from capital gains each year with no tax to pay so, if your potential investment returns are likely to be within the CGT allowance and you pay higher rates of Income Tax, it might make sense to choose to take capital gains instead of income.
Do you hope to pass it on again?
Just as you have inherited, you may wish that others benefit after you’ve gone by inheriting from you. If so, you may need to consider the Inheritance Tax (IHT) implications of how you invest and gift your money.
The rules around IHT can be complicated and complex arrangements for large estates are likely to require financial advice. There are some general points, however, that are worth everyone understanding.
Up to £325,000 can be passed on with no IHT due. This is known as the “nil-rate band”. Your estate can include any money held in cash or investments, property and other possessions. Anything over the nil-rate band can potentially face 40% tax.
Anything that is passed to a spouse or civil partner, however, attracts no IHT at all.
Furthermore, spouses and civil partners can pass unused nil-rate band to each other. For example, a husband who dies and uses only half of their nil-rate band to pass wealth to his children would be able to pass the remaining allowance to his surviving wife, who could then add this to her nil-rate band.
And there is a further exemption if the estate being passed includes a primary residence - a home in which you live. This means an extra £175,000 of nil-rate band per person. At that point, these people will enjoy a nil-rate band of £500,000. This, too, can be passed to a spouse if unused.
Pensions can also be useful when planning inheritance. If you die before the age of 75, anything in your defined contribution pensions can be passed on to anyone you wish and the recipient won’t have to pay tax on it, as long as this is done within two years of the date of death. If death occurs after age 75, then the money withdrawn is liable to income tax at whatever rate the recipient pays.
1,2 Fidelity Inheritance Research, conducted by Opinium Research 7 July 2021