It is better to give, than to receive a painful tax bill

Financial Makeover

Name: Frances PitcairnAge: 70Occupation: Local councillor

Name: Frances PitcairnAge: 70Occupation: Local councillor

Frances works as a local councillor in north-west London and has sufficient income to meet her modest lifestyle. However, the rise in property value has meant that her house is now worth more than £500,000. All her children have left home and have partners so she is considering whether to move.

The adviser: Tim Cockerill is the managing director at Whitechurch Securities, a firm of independent financial advisers based in Bristol. Tel: 0117 944-2266.

The advice: Her main problem, of course, is inheritance tax. With the current threshold at £231,000 her estate is going to suffer a hefty tax bill.

Frances needs to reduce her liability to inheritance tax, and she has started to address this problem. As far back as 1994 she began to give money in the form of gifts to her children. It is possible to give away as much money as you wish, and it falls outside your estate, providing you live seven years after the gift is made. In the event of death within the seven-year period, inheritance tax is charged at a reducing rate depending on how long ago the gift was made. One of the catches with inheritance tax is that it is charged at 40 per cent, irrespective of your income tax rate.

Since 1994, Frances has given away as much of her capital as she can. She is fortunate in that she has a number of pensions from previous employment and this, combined with her council work, provides sufficient income. Being quite sensible, she has left herself with enough money for holidays, a new car and a fund for emergencies.

Every year, you are allowed to make a certain amount of gifts without them being deemed part of your estate. Once again, Frances has been on top of things. The major hurdle, therefore, is how to make provisions for the value that is locked up in her house. The classic solution is to work out the amount of tax likely to be owed. Let us take an approximate figure of £100,000. Take out an insurance policy, paid by monthly premiums, to cover that sum. This is written in trust so that at the time of death the insurance policy pays out a sum equivalent to the amount of tax being deducted out of the estate. The only drawback is that by the time most people start thinking about this problem they are of an age which makes premiums expensive. Whole-of-life assurance for £100,000 would cost Frances £180 per month and she simply cannot afford it.

A partial solution would be to move to a smaller house. Frances has decided that she does not need such a large home and would be able to release around £100,000 which could then be gifted to her children. In an ideal world Frances would move to a house worth, say £200,000, and gift the capital raised. But she wishes to remain in the same area because of her job and property prices do not allow for this option.

One way to solve her dilemma is through a "home income plan" but this requires careful consideration. For the purposes of this exercise we will assume Frances is not moving and has at present a liability to inheritance tax of £100,000. She could arrange, through a Home Loan scheme, to raise equity against the value of the house. This is then used to purchase an annuity which in turn generates a monthly income.

Home Loan schemes allow for up to 25 per cent of the value of the property to be raised in this way. Frances could therefore raise £125,000 and, if we assume an interest rate of 7.5 per cent net, this would generate an annual income of £9,375. She would now be in a position to take out an insurance policy using the annuity payments to fund the premiums. This policy should be written in trust so that it is outside the estate and will be written to cover the inheritance tax liability. Obviously, the company arranging the loan will need to be repaid and that will come about through the sale of the property, so overall, the potential inheritance tax bill is reduced.

Taking this procedure one step further, Frances does not have to raise 25 per cent of the property value, she could raise 10 per cent so that, with a little bit of careful calculation, she could arrange for a loan against the property which generates enough income to cover the premium for the life policy, leaving almost no excess income. This then leaves more of the house value to the children while covering the inheritance tax liability.

A final option is for the insurance premium to be paid for by the four children, all of whom are working. I am afraid that it is all rather convoluted and needs to be considered carefully, but it is one potential solution to Frances's problem.