Martin Lewis has highlighted little-known ISA rules, including a 3-year time limit after which ISA holdings could incur a tax bill. ISA accounts let you save or invest money without paying income tax, Capital Gains Tax, or dividend tax on your returns. However, the Money Saving Expert founder explained that when an owner dies, the taxman can pounce when the funds are passed on.
How ISAs are treated after death
Speaking on his BBC podcast, Mr Lewis explained how ISAs work when a person dies. While returns within these accounts are entirely tax-free, it changes when an owner passes away. He said: "ISAs protect you from the current tax that you have on them. So in a Stocks and Shares ISA, any capital gains—so that's the gain that you make on a profit, any profits that you make when you sell it—they are not there because it's sheltered within an ISA wrapper."
"Income tax on dividends is pretty much the same as savings, you know, making interest on savings. So if you're getting income tax on dividends from your funds or shares within your Shares ISA, again that is protected."
Mr Lewis also reminded savers that ISAs not being taxable means that they do not count towards your other allowances. In the UK you can earn up to £12,750 each tax year without having to pay tax. However, any additional funds you derive from your ISA will not count to the tax-free amount.
The 3-year rule
Nonetheless, the taxman may come knocking when the time comes to pass on those funds. Mr Lewis said: "But when you pass an ISA on when you die, it is part of your estate." As such, it is liable for inheritance tax, WalesOnline reports.
Fortunately, there is a bit of leeway here for your inheritors. The consumer expert said: "Rule number one, the ISA status, when you die, stays tax-free—a continuing account until administration of the estate ends or the third anniversary of death, whichever comes first, but no new money can be paid in. So it stays tax-free."
"When it's moved on, then it counts towards your inheritance tax allowance that we talked about earlier, £325,000. It would count towards that allowance. It's part of your estate. So it's just money that you've got."
This means that the funds you retain from your ISA accounts will remain tax-free for either three years after your passing or until administration of the estate ends, whichever comes first. It then becomes part of your estate, meaning it will be taxed on.
Each individual can pass on up to £325,000 in total assets without paying inheritance tax on this, and an additional £175,000 allowance. You can pass on any unused allowances to your spouse or civil partner when you die, so they can potentially pass on up to £1 million in assets tax-free. Inheritance tax is charged at a standard rate of 40%.
Special rule for spouses and civil partners
There is another important tax-free rule when passing on your ISAs. Married couples and civil partners can benefit from an extra tax perk called the Additional Permitted Subscription (APS).
Mr Lewis said: "There is a special rule for your spouse or civil partner—so your married or civil partner, not cohabiting, not your kids—that they can get an extra ISA allowance of the same as your allowance when you died."
The APS lets the surviving partner claim an additional ISA allowance equal to the value of their partner's ISAs at the time of their death. The financial expert gave an example of how this applies: "So if you've got £50,000 in ISAs, they can get an extra £50,000 tax-free ISA allowance."
Similar to the three-year rule that keeps your ISAs tax-free, the surviving partner gets this extra allowance up to three years from the date of death, or up to 180 days after the estate is settled.
Another benefit to the APS is that your ISA savings can be passed to someone else while the partner keeps the tax allowance. Mr Lewis explained: "And interestingly, I could give my child the money [from the deceased person's ISAs], but I could still pass the allowance on to my spouse."
Claiming the allowance and upcoming changes
To access this extra allowance, you must contact the bank or building society directly. Mr Lewis said: "They [the surviving partner] can apply for it, but it's worth noting you have to apply to your ISA provider to get it, and not all ISA providers will allow you to have it." If your provider does not offer the APS, you can transfer the ISA to a provider that does.
While planning ahead for your ISA savings, you may want to note some key rule changes taking effect very soon. You can currently pay in up to £20,000 a year into ISAs, and you can divide this as you see fit between the different types of ISAs, across one or more accounts of each type. From next year, you will only get a £12,000 allowance you can use however you want. The other £8,000 will only be available for deposits into investment-based ISAs, like stocks and shares ISAs. People aged 65 and over will retain the current £20,000 allowance. You will qualify for the full £20,000 allowance in the tax year that you reach the age of 65.
