An inheritance often feels like something to deal with and move on from. In reality, it is one of the few points at which a small, well-timed decision can have a lasting impact on your finances and your family’s future.
If you inherit assets outright, they become part of your estate and will be taken into account for inheritance tax purposes on your death. With nil rate bands frozen and inheritance tax rules evolving, over the coming years, more and more estates are likely to become subject to inheritance tax.
Against this backdrop, bringing additional assets into your estate (particularly later in life) can create tax exposure where none previously existed. For that reason, it is worth taking advice before making any decisions, in particular, one of the key tools that may be considered upon receiving an inheritance is a deed of variation.
What is a deed of variation?
A deed of variation allows a beneficiary to redirect all or part of an inheritance, either to another individual or into a trust. If done correctly, HMRC will treat that change as if the person who died had left these instructions themselves.
Example 1: a flexible solution
Annie is divorced and has one son. She has assets of £750,000. On death, her estate would be subject to inheritance tax of £100,000. Annie then becomes entitled to an inheritance of £250,000. If she takes that inheritance outright, her estate would grow to £1Million and the inheritance tax bill would be £200,000.
Rather than taking the inheritance personally, Annie could instead enter into a deed of variation to redirect the inherited funds into a discretionary trust. The class of beneficiaries would include Annie herself, her son and wider family.
This structure would reduce Annie’s inheritance tax exposure by 50%, while also giving her family much more flexibility, including:
- As a potential beneficiary, Annie could still benefit from her inheritance during her lifetime whilst ringfencing it from inheritance tax exposure. There are different ways this can be achieved depending on Annie’s individual circumstances and what she wants to do – for example pay off her mortgage or invest the funds to plan for her retirement.
- If Annie didn’t need her inheritance, the trustees could purchase a property for Annie’s son to live in. This can safeguard the funds from any future claims her son may face on divorce or separation, or from financial instability.
- Alternatively, the trustees could lend funds to Annie’s son to assist with the purchase of a property in his own name, while allowing the same safeguards to remain in place. This may work better if Annie wanted to retain some of her inheritance whilst also helping her son get on the property ladder.
- If appropriate, depending on family circumstances, funds could also be distributed to beneficiaries outright.
This type of arrangement achieves a significant tax saving (£40,000 per £100,000 of inheritance if inheritance tax is an issue) while giving the family flexibility to manage the inherited wealth as circumstances change, while also offering a level of financial protection.
Example 2: a simple solution
Ben and Cathy are married and in their 60s, they have two children. They have combined assets of £1 million, including their home, cash and investments. Under current rules, they can pass this wealth to their children without an inheritance tax liability.
Cathy then inherits £300,000 from her mother. If she takes this inheritance outright, their joint estate increases to £1.3 million, creating an inheritance tax bill of £120,000.
Ben and Cathy are comfortable and want to use the funds to help their children get on the property ladder. Cathy could choose to gift the inherited funds to her children. This would help them purchase their own homes. However, if Cathy was to die within seven years of making the gift, these funds would still be taken into account for inheritance tax purposes, so outright gifting carries some risk.
Instead, Cathy could use a deed of variation to redirect the £300,000 directly to her children. In that case, the funds would not form part of her estate at all, and the inheritance tax exposure is avoided immediately.
What about cohabiting partners?
Deeds of variation can be particularly beneficial for cohabiting partners, who do not have the same tax allowances that married couples and civil partners do. In the right circumstances, a deed of variation can help by redirecting assets away from the surviving partner’s estate into a trust, which has its own separate nil rate band, and provides an inheritance tax saving of £130,000 as the starting point. A trust can allow the surviving partner to benefit from the assets during their lifetime, without them forming part of their own estate for inheritance tax purposes.
What if there is no will?
A deed of variation can also be used where someone has died without a will. Intestacy rules fix how an estate is divided, which may not always produce the most practical or tax-efficient results.
For example, under these rules, cash assets over £50,000 will be divided between a surviving spouse and children (with one third passing to the spouse and two thirds to the children). This can quickly use up the available inheritance tax allowances and may result in an unexpected inheritance tax liability arising. This would not be the case if the deceased had left a will passing the estate entirely to the surviving spouse, as the spouse exemption would apply.
A deed of variation can adjust that position so that assets instead pass to the surviving spouse, either outright or via a trust to ensure assets are preserved for the children in due course. This can remove the immediate inheritance tax liability and allow further planning to minimise inheritance tax on the death of the surviving spouse.
What if I inherit from a foreign estate?
It is also possible to vary an inheritance received from abroad where the beneficiary is a UK long-term resident for inheritance tax purposes. For more detail, see our recent article.
Timing
Timing is key. To be effective for tax purposes, a deed of variation must be completed within two years of the date of death. This deadline cannot be extended. Taking advice early helps ensure the available options are not missed. You do not need to wait until an estate is finalised or you have received payment of your inheritance to think about this.
Final thought
An inheritance brings with it a number of choices. Taking a moment to consider those options can make a meaningful difference to how that wealth is used and preserved for the future. If you are due to receive an inheritance, it is worth exploring whether a deed of variation is appropriate for your circumstances. The personal team at Brodies can guide you through the options available.
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