Seven ways to shape up an inheritance

What you’ll learn:

• The tax implications of a legacy
  
• How age can influence decisions on what to do with the inherited investments
  
• Why a will can help you ensure you can pass on your investments smoothly to loved ones.
  

An inheritance of any sort is sure to be a welcome windfall. But if it arrives in the form of an investment portfolio it can raise certain challenges, whether you’re a seasoned investor or have never dabbled in the stock market in your life.

Should you keep such a portfolio intact, cash it in or use it to rebalance what investments you own already?

What you do will probably depend on what stage of life you’ve reached and whether you plan to spend the money immediately, perhaps to pay off debts, or salt it away for the future.

How you feel about risk is also important. And if your new portfolio reflected the needs of an elderly relative’s finances, it’s unlikely to be designed to meet your own money goals.

If you decide to use the legacy to help build your own financial future, then you might need to quickly get to grips with the language of the stock market and consider whether it is time to re-calibrate your financial aspirations.

If it all seems too much to do yourself, there is always the option of seeking financial advice from an expert financial planner who can help set you on the right track – and support your journey.

Here’s what you need to consider:

1. The good news on capital gains tax

One big advantage under current tax rules (which the Government could change at any time) is that Capital Gains Tax (CGT) is not charged when someone dies. Mike Romatowski, financial planning expert at Barclays Wealth Management, said: "This means if any property or shares they owned had gone up in value since they bought them there would be no capital gains tax to pay on this gain after their death. Not having to pay CGT allows you to save quite a bit."

Had your benefactor sold the investments while alive, they may have had to pay tax on any gains, unless they were held in a tax-friendly ISA or pension, the rate of which varies depending on a person’s income tax bracket and how much gain was made.

Most people have a CGT allowance of £3,000 in the tax year 2024-25 after which you owe tax at 10 per cent or 20 per cent depending on your income tax bracket. There is an additional surcharge to be paid on residential property (other than your own home) and carried interest gains. Basic rate taxpayers will pay 18% and higher rate taxpayers would pay 24% on such a gain over the annual allowance.

Basic-rate taxpayers would need to calculate whether the gain – minus their annual allowance – will push their income into the higher-rate band. If it does, everything above the band will be taxed at 28%, and everything below it will be taxed at 18%.

Be aware that if assets bequeathed to you rise in value between the date of death and you receiving them, you might incur a tax charge if you sell them.

2. Getting to grips with death tax

Assets left when people die may be subject to inheritance tax (IHT) – charged at 40 per cent on estates valued at more than £325,000 (or £650,000 if the deceased was married or in a civil partnership and their partner died before them and did not use all of their own allowance).

There is also something called the residence nil rate band that can increase the IHT free limit to £500,000 per person where the main residence is transferred to a direct descendant on death and the total estate is valued below £2,000,000. This can also be transferred to a surviving spouse if not fully used on the first death.

So a couple can potentially pass on £1,000,000 free of inheritance tax. Where an estate is valued between £2,000,000 and £2,700,000, the government reduces the residence nil rate band by £1 for every £2 the estate is valued over £2,000,000. As such, an estate worth £2,700,000 or more will not benefit from the residence nil rate band.

If your benefactor had their affairs well organised, there will hopefully be no inheritance tax to pay. And if there is a charge, it will usually be deducted by the executor before you receive your portion.

Defined contribution pensions, the most common type of pension nowadays, are generally considered outside of the estate for inheritance tax purposes and therefore normally do not incur IHT. Other taxes may be payable on inherited pensions, however.

If investments you inherit were previously held in a tax-free ISA, the tax advantages normally disappear on death. ISA tax shelters can only be inherited intact if left to a spouse or civil partner.

3. Understanding how you feel about risk

If you’ve never invested before you might feel anything from elation to anxiety at inheriting a collection of shares or funds. Even though it is a gift the last thing you probably want is to see it fall in value. Unfortunately, this cannot be guaranteed with investments. Their nature is to rise and fall in value over time.

You do need to ask yourself what you’d feel if the portfolio dropped in value – as many people experienced when the coronavirus crisis struck. Romatowski said: "People tend to feel an emotional impact when they experience losses way more than they do from making gains."

He suggests taking a risk questionnaire (plenty are available online or via a financial planner) to gauge what your response might be.

He added: "To give you an idea, just think about what you might have felt when you’ve bought a tv set and then see it for 20% less in a shop down the road. If that makes you feel really upset that suggests you are risk averse. If you don’t feel that bothered, then you can probably tolerate more risk."

If you can accept the possibility of losing in return for the potential to make gains then you might feel comfortable with investing.

4. The importance of assessing your assets

If you’ve been handed a mixed selection of assets you’d be wise to assess them against what you already own. If you check how heavily skewed they are to one type of asset or sector or even by single company you can consider rebalancing the pot by rearranging them or putting new cash into something different.

Romatowski said: "If you inherit shares in just a few companies you might find there could be wild swings in performance. Your risk is highly concentrated. And with individual companies you really need to keep monitoring them. To reduce the risk you could look at collective investments such as unit trusts, open ended investment companies, Investment Trusts that invest in many other companies."

The advantage of these kinds of funds is they are professionally run, with managers trained to research the companies and figure out what they believe will be the winners and losers.

Romatowski added: "They command high wages for the work that goes into selecting and managing the underlying investments, so you pay charges for this work. With directly held and chosen shares, such charges are not applied. But the advantage is that even with just one fund you will have instant diversification across a collection of different companies, possibly 60 or 70, and have access to ones that might be difficult to buy individually because the price of a single share is so high."

5. How your age can influence your choices

Age is likely to dictate what action you take. If you receive an inheritance at 30 it might immediately go towards paying off the mortgage or, if you’re in your 40s, to help with the cost of raising a family. But if it does not get earmarked for such spending then an inheritance can suddenly represent a large proportion of the assets you own.

If you are older, and have already built up significant savings and investments the sum you inherit may account for less of your total wealth.

Either way it may not be an appropriate selection of investments to support your own personal goals and you might need to fine-tune the pot.

Romatowski said: "Mum or Dad might have left you a portfolio designed for someone in their 80s or 90s, perhaps one that is heavily income oriented. That might not be right for someone in their 40s or 50s."

Don’t forget to attend to the basics, including having enough cash reserves both for emergencies and short-term savings goals (when you need the money in less than five years time) and checking that any investments you choose have the potential to meet your future aspirations. At the same time you must feel at ease with the level of risk you’re taking. It may be ‘free’ money but that doesn’t mean you want to lose it all by taking unnecessary risks. If in doubt, seek financial advice.

6. Passing your assets on to others

If you wish to keep your own wealth from being caught in the inheritance tax net there are two common ways to do this: either have fun by spending it while alive and reduce the value of your estate to at least the ‘nil rate band’ - the level where it escapes the tax (currently this is £325,000 to £500,000 for an individual, depending on the size of the estate and if a property is involved); or give your assets away to others in your lifetime.

There are several exemptions available under the rules, although this could change in future. These include handing out gifts worth £3,000 a year plus any number of £250 sums to different people, so long as they don’t receive anything under a different exemption.

It is also possible to give away any amount and there being zero inheritance tax to pay – under a so-called potentially exempt transfer. For this to happen you must live for seven years after you’ve handed over the assets, whether it’s property, shares or cash.

If you don’t survive the full seven years, tax is charged at 40% on gifts made in the three years before your death, then on a sliding scale until the seventh year is up. If you do die within the seven years, this can create problems for the beneficiary, especially if they have spent it as soon as they receive it, as they’ll have to meet any IHT bill.

If you hand over non-cash assets, you might have to pay capital gains tax at the point of transfer if the asset has risen in value since you purchased or inherited it. How much you pay, if anything, will depend on individual circumstances.

If you are married or in a civil partnership, your whole estate can pass free of tax to your spouse or partner via your will, who will also inherit any unused nil rate band. This potentially doubles your loved one’s own band on death to £650,000. An exception might be if your spouse makes bequests to other people in their will or made gifts within seven years of death. Inheritance tax might then apply and might also use up part or all of their nil-rate band. It all depends on how much they bequeath or give away.

7. Consider the importance of wills

If you’re worried about your family having to fork out tax on your legacy, you can consider taking out life insurance to cover a potential bill. This needs to be written in trust if you want it to be outside your estate for tax purposes. If you are unsure if this is right for you, you should seek independent financial advice.

And if you want to be certain your hard earned wealth goes to the people you want to enjoy it – then ensure you draw up or review an existing will. If you die without one – intestate, as it’s known – your investments and other property will be divided up according to strict rules that might not be what you’d hoped for.

If you’re concerned that your beneficiary – a grandchild perhaps – would have their head turned by an inheritance at too young an age, you might consider setting up a trust and instruct the trustees to control the investments within it until the child is older. There may be inheritance tax due when the assets are settled into the trust and also periodically during the life of the trust depending on your personal circumstances. If you are considering setting up a trust, it is good practice to involve a qualified legal or tax adviser, so as to avoid complications.