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The exemption that could save you 40% on tax!

In the financial year 2021/22, HMRC received the highest amount of inheritance tax receipts since records began. The exchequer received £6.1 billion, which was an increase of 14% on the previous year (Source: HMRC). With inheritance tax thresholds being frozen until April 2028 and the rate remaining at 40%, HMRC can often end up being the largest beneficiary of bigger estates, presenting a significant drag on the transfer of wealth between generations. As a result, more and more families are choosing to pass on wealth through gifts during their own lifetimes. Not only does this allow older generations to witness their loved ones benefit from gifted wealth, it can also reduce the tax burden. 

This trend has only been further exacerbated by the recent cost of living squeeze, with evidence suggesting that younger generations are being burdened disproportionately when compared with their parents and grandparents.

The first consideration of effective gifting is to guarantee your financial security for the remainder of your life; in other words, ensuring you can meet your expenditure and wider objectives (such as care fees). Once this has been satisfied, the next consideration is using available allowances.

Annual gifting allowance, small gifts and wedding gifts

For those wishing to pass on wealth during their own lifetime, each individual has an annual exemption allowing them to gift away £3,000 each year without the gift being added onto their estate for the purposes of inheritance tax. Where this has not been utilised before, a previous year can be brought forward, allowing initial gifting of £6,000. 

On top of this, individuals can also make small gifts of up to £250 which are unlimited in quantity provided they are not made to the same person.

There are additional allowances for weddings and civil partnerships, where the exact amounts are determined by the relationship to the couple:

  • £5,000 to a child.
  • £2,500 to a grandchild or great grandchild.
  • £1,000 to anyone else.

It is worthwhile noting that gifts to political parties are also exempt, as are those made to registered charities.

Lifetime gifts and Potentially Exempt Transfers

Aside from the above allowances and exemptions, any other gifts made during an individual’s lifetime may be classed as ‘Potentially Exempt Transfers’ (PETs), meaning that should an individual die within 7 years of making a gift, it will only be chargeable to inheritance tax (with taper relief applying after 3 years) if the gift exceeds the available nil rate band. PETs that don't exceed the nil rate band just have the effect of using up nil rate band for 7 years, and taper relief is irrelevant. The rate at which tax is payable on the gift depends on time elapsed between gifting and death. Gifts made in the 3 years prior to death will be chargeable to inheritance tax at the full rate of 40%, however those given 3 to 5 years prior to death will be subject to ‘taper relief’ meaning the rate of tax is reduced as follows:

Years between gift and deathRate of tax on the gift
3 to 4 years

32%

4 to 5 years24%
5 to 6 years16%
6 to 7 years8%
7 or more0%

Where gifts are made into a Discretionary Trust, these will be classed as Chargeable Lifetime Transfers. There could be a tax charge on the gift into the Trust.

Gifting from income

The above is arguably an assumption on gifting capital and one-off gifts from income, as other gifts from income are treated differently, such as regular gifts. This rule can often be overlooked by those wishing to minimise inheritance tax drag on their estate. However, when utilised properly, the allowance can have a considerable impact in reducing the amount of an estate that is chargeable at 40%. Gifts made from excess income are exempt from inheritance tax subject to certain criteria:
Firstly, this rule is only applicable to net excess income that is left over after all of the gift-giver’s own regular expenditure has been met. Crucially, this means that any gifts must not impact the gift-giver’s own standard of living.

Any gifts must form part of your normal expenditure, meaning that there must be an observable, regular pattern, should HMRC decide to audit any records. As such, it is advisable to keep a clear record of all gifts to ensure that this is easy to evidence. As the exemption is only claimed on death, this will also be invaluable to the executors of the estate, who will be required to complete an IHT 403 form which contains a section for all gifts and transfers of assets to be detailed.

Clearly, exactly what is classed as income is centrally important to this rule. As the name would suggest, gifts have to be from income and cannot be from capital (i.e. selling down investments). Earned income from employment qualifies, as does rental income, income from a final salary (defined benefit) pension and dividends from investments.

Provided all of the above criteria have been met, there are no limits as to how much of your surplus income can be gifted away annually.  Therefore, at least until any potential care costs are needed to be paid for, individuals could start to gift excess investment or pension income away, which over time can save estates significant IHT liabilities. For example, a couple with combined pension and investment income of £65,000 (net) per annum, whose total expenditure is £50,000 per annum could potentially gift up to £15,000 per annum without incurring inheritance tax implications.

Key considerations when gifting from income

Gifts must form part of a regular pattern of gift-giver's payments

There must also be evidence to suggest the gift-givers intention for this to continue e.g. a standing order.

Gifts must not impact the gift-givers standard of living

Only income that is left after all of the gift-givers expenditure needs have been met can be gifted away

Keeping a record

It is prudent to maintain a schedule of gifts, detailing amounts, dates and recipients. This will make things much easier for your executors when you pass away.

How we can help

A cohesive approach in succession planning is vital in ensuring that wealth is structured appropriately and gifting considers the relevant allowances. The matter of control and gifting is an essential subject to consider because, once a gift is made, the gift-giver cannot exercise control or decisions on this money, unless it is gifted into trust and they are a trustee.

Succession planning can vary between making effective use of gifts and maximising income to distribute during one’s lifetime through to legal structures and investments which maintain control although begin steps to reduce an Estate for Inheritance Tax planning.

If you would like to know more about how we can help keep more of your wealth for your loved ones, contact us to speak with an expert adviser.

Arrange a free initial consultation

Note: A pension is a type of investment, the value of investments can go down as well as up and you may not get back what you originally invested. The FCA does not regulate estate or tax planning or cash-flow modelling.