If I leave my home to my foster children, will they pay inheritance tax?

We have no children, but were foster carers to two young girls, one is now 19 years old and the other is 16 years old.

We have no need to leave money to close family, as they are all have sufficient and stable finances.

We wish to leave any assets to these young women, but in a way that protects them from potential ‘predators’, or their own lack of financial acumen, but gives them support as and when needed.

If we continue to be in reasonable health, and if we can afford to do so, we would like to help them as they grow up. N.H, via email

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Harvey Dorset, of This is Money, replies: Being without children of your own, it is admirable that you have chosen to take in two foster children and help to build them a life, including using your assets for their benefit as they grow.

That being the case, it is even more commendable that you wish to leave yours and your wife’s assets to these two young women – passing on the wealth you have build to help them with their own futures.

It is also wise of you to consider that they might not know how to manage such a large sum, or that they could be taken advantage of by others.

The good news is that when leaving assets to foster children, you are allowed to make use of both your combined £325,00 tax-free allowances and crucially your £175,000 residence nil-rate bands.

This is because foster children are considered as direct descendants for inheritance tax purposes at the time they are fostered and subsequently. That means you can benefit from the residence nil rate band for passing on your home to direct descendants.

In order to find out how you can ensure your foster children are supported after your deaths, as well as protected from making bad financial decisions or being taken advantage of, This is Money spoke to two financial advisers.

Hazel Bowen, senior wealth planner at Cannaccord Wealth, replies: You would like to leave your assets to these two young women.

Here are the considerations you need to make:

Nil rate bands and exemptions

Each individual has a nil rate band (NRB) of £325,000, meaning the first £325,000 of their estate can be passed on inheritance tax (IHT) free. If gifts are made within seven years before death, they may reduce this allowance.

For homeowners, there is an additional Residence Nil Rate Band (RNRB) of £175,000 per person, provided the property is left to lineal descendants (children, stepchildren, grandchildren, adopted and foster children).

For married couples or civil partners, assets passed to the surviving partner are exempt from IHT, allowing any unused NRBs to be transferred. This means that a couple can benefit from a combined NRB of up to £650,000 and a total IHT-free allowance of up to £1million if they qualify for the RNRB.

Inheritance tax on surplus assets

Any estate value exceeding the combined allowances is usually taxed at 40 per cent, unless further exemptions apply.

Residence nil rate band (RNRB) requirements

To qualify for the RNRB, the property must be directly inherited by lineal descendants. Broadly speaking this means:

• The property cannot be placed into a discretionary trust where beneficiaries’ rights to the property are not defined

• The inheritance must pass outright, usually meaning the child inherits at age 18

There are exceptions to the above rules, including when a parent dies and leaves residential property to their minor child. In this circumstance, it is possible to establish a trust with a contingent age of 25 without loss of the RNRB.

Using trusts for controlled wealth transfer

Leaving assets outright to children and within their control from age 18 may expose the inheritance to poor financial decisions or external risks (e.g. divorce or creditors). A better approach could be a discretionary trust, where named trustees manage and control the inheritance on behalf of the children. If a will trust is used, the couple can still pass on up to £650,000 tax-free. If the trustees appoint residential property out of the trust during two years from the date of death the RNRB can be claimed.

Gifting during lifetime

The couple may wish to support their children financially while they are alive. They can take advantage of:

• Annual exemption: each parent can gift £3,000 per year, free from IHT.
• Larger gifts: additional gifts are allowed but would reduce the available NRB if made within seven years of death.
• Gifts from excess income: regular, affordable gifts from excess income can be completely IHT-free if properly documented.
• Special occasion gifts: additional exemptions apply for milestone events, such as marriage.

Financial planning considerations

Before making any significant lifetime gifts, it is essential the couple assess their own financial stability and ensure gifting to their foster children does not compromise their own future cash flow. Seeking professional financial advice can help the couple navigate IHT rules and plan their wealth transfer efficiently. It is also essential to take professional legal advice when drafting your will to ensure it effectively balances objectives of minimising taxes and protecting wealth.

Patrick Haines, partner at Partners Wealth Management, replies: There is a range of good planning options which should be considered for our foster carers. These structures will ensure the future financial security of the young women but without them having access directly.

Wills and powers of attorney – where you have some form of responsibility for others, young or old, it is vital to ensure you have a correctly drafted will and that this is reviewed on a regular basis – perhaps every five years or when a ‘life event’ takes place. In the same way, a power of attorney will help to ensure decisions can be made on behalf of our foster carers in favour of the young women in their care, should they lose mental capacity. Guardians should be appointed, at the very least for the 16-year-old, to ensure a responsible adult can take on any care needs should the foster carers pass away.

Discretionary trust – this can be arranged by the same legal professional and can either form part of the will or be separate from it. Either way, this structure can ensure there is money available to support the young women for the rest of their lives but without them physically having access to the ‘pot’. The trustees are the legal owners and can advance money to the young women whenever needed. Simple to arrange and fairly straightforward to administer.

Letter of wishes – this would be linked to the above trust and would clearly set out how the funds should be used and to potentially include any maintenance and/ or education needs for the girls.

Pre-nuptial agreement – thinking further ahead, our carers should start discussing the benefits of having a ‘pre-nup’ arranged when they become involved in a more serious relationship. These now have legal standing in the UK and can be vital to protect assets should any relationship turn sour.

Cohabitation Agreements – similar to the pre-nup, this is a useful tool to make clear who has contributed what when moving in with others – particularly where property is being purchased and each person is investing different amounts into the home.

Life cover – as you are in reasonable health, a life assurance policy could be arranged to provide a sizeable sum on their deaths which could then provide for future income or capital needs such as money to purchase a home. The policy should be written under trust.

Pension – even if the young women are not earning, you could arrange a pension for each and invest £3,600 annually. The young women would not have access to the pensions until at least age 57 but this could provide a sizeable fund of around £500,000 each by the time they retire.