ISAs and Inheritance Tax: what you need to know

If you’ve built up a significant amount of money in ISAs over the years, you’ll need to know how the rules around Inheritance Tax (IHT) affect this kind of savings account, as they can pay a crucial part in making sure the people you care about are looked after. 

Thinking about how you’re going to pass them on to family or other loved ones is important – there are allowances and changes to tax status to consider, depending on who you intend to give them to. 

So, if you’ve been steadily accumulating money in your ISAs, or just put windfalls in there over time, there are a few steps you can take that might make things easier for your family in the years ahead. 

• How to cut your tax bill with an ISA 

Why should someone save into an ISA? 

Before you start thinking about what you’ll need to do with any ISAs you hold, it’s important to check you’re still using them in the right way for you. 

If you’ve been slowly paying money in (or just put a lump sum in there), you might not be fully aware of the important ways they differ from an ordinary savings or investment account. 

Or, that there's a £20,000 limit per year to the amount you can put into them (across all ISA accounts you hold.) 

One of the main reasons to pay money into an ISA is the value of the tax benefits, which can increase considerably over time.  

“What normally happens with savings and investments is that, as you accrue more money and your holdings grow in value, the potential for Income Tax and Capital Gains Tax grows and grows as well,” explains Martin Stanley, Chartered Financial Planner at independent financial adviser Rowley Turton.  

“But if you've been careful to shelter money using your ISA allowances, however, you can breathe easy: there’s no tax to pay.” 

Olly Cheng, Financial Planning Director at wealth management company Rathbones, adds: “ISAs are an incredibly tax-efficient way of saving, and offer a good complement to pensions.  

“Because there is no tax payable when money is withdrawn, they allow investors to manage their annual Income Tax bill in retirement by drawing from a blend of ISAs and pensions.” 

Currently, defined contribution pensions are not usually subject to Inheritance Tax, so if you switch to spending money from your ISA, you can help mitigate the effect of IHT by passing on a pension rather than a savings account.  

Doing this also has the additional benefit of lowering your tax bill, due to ISAs being Income Tax free compared to pensions. 

Stanley points out that ISAs can also be useful for older people wanting to stay protected from a sudden need for funds:  

“Especially for retired people, it’s important to have an emergency fund in the bank – and why pay tax on the interest if you don't need to? Putting it in a cash ISA means that you’re keeping more of your money.” 

• Why emergency savings are crucial – and how to build them 

What happens to my ISAs when I die? 

If you're concerned about how your assets will be shared out, it’s important to understand the role ISAs can play. “When it comes to inheritances, ISAs have another advantage for spouses and civil partners,” explains Stanley.  

“The ‘additional permitted subscription’ (APS) rules effectively mean that ISAs can be passed over into the name of the surviving partner without losing the valuable tax exemptions.” 

Regardless of whether they're actually left the contents of the savings account, the APS means a spouse or civil partner can boost their own tax-free savings and investments by the value of the deceased’s ISAs. 

Essentially this means they can make one-off additional contributions to their ISA above the £20,000 per year allowance, sheltered from tax, which could be quite a bit of money.   

Outside of this scenario, though, and beneficiaries will need to start thinking about potential tax implications. Nick Winter, Financial Planner at wealth management company Quilter, says: “For beneficiaries other than a spouse or civil partner, the ISA’s tax-free wrapper is lost upon your death.”  

This means anyone inheriting assets from an ISA may become liable for Capital Gains Tax on inherited stocks and shares, or Income Tax on interest from savings or dividends from shares after they inherit them. 

“It's important to remember that ISAs don't help you with Inheritance Tax,” adds Stanley. “Except for spouses and civil partners – where [it currently] doesn't apply – ISA money is still subject to Inheritance Tax if it takes you over the threshold.” 

At present, each person has a £325,000 tax-free limit for IHT, known as the nil-rate band, plus up to a further £175,000 if you’re passing on a family home to children or grandchildren. Any portion of an estate valued above this amount can be subject to tax at 40%. 

• Inheritance Tax payments climb to record £6bn – here’s what you can do about it 

 “It’s crucial to plan how your ISAs will be managed within your estate to minimise potential tax bills,” Winter adds, pointing out how ISAs could be used to help families who might struggle with an IHT bill.  

“Some individuals may use ISAs to pay for any IHT liabilities, especially if other assets - such as property - are illiquid or more difficult to sell.” 

Stanley highlights one niche area where an ISA could affect IHT: “The one exception to the IHT rules is a special kind of ISA that invests in small-company shares that are listed on AIM [the UK’s Alternative Investment Market].  

“Beware, however, because these are classified as very speculative investments, so investors would definitely want to speak to a professional adviser on this.” 

As mentioned, AIM shares are inherently more risky than ‘normal’ investments, and investors shouldn’t put in any money they cannot afford to lose. Not all AIM stocks will qualify for IHT either – any potential investors should make sure they’ve spoken to a regulated professional to ensure they’ve fully understood the risks of adding AIM assets to their portfolio. 

This also may change in the future, as the new Government has scheduled its first Budget for the end of October, and there could be some amendments made to the ISA system.  

“[With the] more obscure ISAs, such as innovative finance ISAs and AIM ISAs, it would not surprise me to see these non-mainstream options changed or even abolished,” says Stanley. 

What other options do I have? 

Stanley explains: “Sometimes, people think ISAs are the be-all and end-all of saving and investment just because they’re tax free.  

“However, because they're not Inheritance Tax-free, there often comes a point in later life when it’s sensible to think about alternatives. Sometimes, it can be a good idea to take money out of ISAs in order to focus on IHT planning instead.” 

Winter adds: “While ISAs remain beneficial for preserving wealth, if your primary concern is inheritance planning, there may be other financial vehicles that could offer better estate planning advantages, depending on your circumstances.  

“For example, you might consider taking out a life insurance policy specifically designed to cover your IHT liability.  

“By placing this policy in a trust, the proceeds can be paid out directly to your beneficiaries without increasing the value of your estate, thus providing them with the funds needed to settle any tax bill without having to sell other assets.” 

However, trusts can be complicated to set up and there may be costs and tax to consider, so they’re not for everyone. If you’re thinking of taking this route, it’s very important to get professional advice. 

Cheng points out that giving money away can be another way of reducing potential IHT liabilities, especially if your ISAs are well-funded. “As with any other asset, you can consider gifting monies from your ISAs during your lifetime.  

“If you survive for seven years, the gifts will be free of Inheritance Tax.” However, he adds that the money will need to leave the ISA to be given away, and therefore won’t be sheltered any longer from tax and, again, could be subject to CGT and Income Tax in the future.  

Whatever course of action you decide on, it’s vital to ensure you've got an up-to-date will. “We would always recommend having a will in place, even if your affairs are relatively simple,” says Cheng.  

“As one example, if you have children, the default under intestacy rules isn’t necessarily for all of your assets to pass to your spouse on death [which could then trigger an IHT charge]. 

“Unlike pensions, which [currently] pass outside of your estate based on an ‘expression of wishes’ form lodged with the pension trustees, your ISAs pass according to your will.  

“So, if you have substantial ISA savings, it’s a good reason to make sure your will is up to date.” 

Key takeaways 

• If you’re married, your spouse or civil partner can get a one-off additional ISA allowance after you’ve died, equivalent to your ISA wealth. This is known as an additional permitted subscription and it applies even if you leave the contents of your ISA to someone else. 
• ISAs are not IHT free and will form part of your estate – unless the money is passed onto a spouse or civil partner (where all transfers of wealth are IHT-free if properly left in your will).
• In your later years, building wealth in ISAs won’t be the be all and end all – if you’ll likely pay IHT on your estate, the time may come to spend the money.