Interactive Investor

Use this lesser-known trick to cut your IHT bill

Making regular gifts from income is an underused estate-planning tactic but can be one of the most effective. Rachel Lacey explains what you need to know.

19th February 2024 13:56

by Rachel Lacey from interactive investor

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If it’s looking like you’ll need to pay inheritance tax (IHT) when you die, the chances are you will already be familiar with many of the gifting rules.

Giving money away while you are still alive is the most straightforward way of reducing a potential IHT bill – it can be the difference between your loved ones getting £1,000 now or £600 once you have died and 40% tax has been deducted.

Each year you can give away £3,000 tax free and make as many gifts of up to £250 to different people as you would like. There are also special allowances for weddings; you can give a child £5,000 when they marry, £2,500 to grandchildren or great grandchildren or £1,000 to anyone else.

Any lump sums you give in excess of the allowances are considered potentially exempt transfers, which means the amount of IHT you pay on them reduces over time until seven years have passed and the gift becomes totally tax free.

However, there is a way to make unlimited gifts tax free, irrespective of how long you live that fewer people are aware of and that’s the regular gifts from income exemption.

Gifts from income explained

You can give away as much money as you like – without worrying about IHT – so long as payments are regular and you can afford to make them from your normal expenditure.

Over the years, employing this strategy can take huge chunks out of your taxable estate and reduce the amount of IHT your loved ones eventually pay. But on top of that, it can also give you the ability to help your family and see them get the benefit of your wealth before you pass away.

For example, if you have a child that is struggling with rising mortgage costs, giving them £500 a month for a period of three years would take £18,000 out of your estate. This would not only ease their money worries, it could also save them £7,200 in tax.

But smaller, more manageable, payments can also be effective in reducing the value of your estate over time. A monthly payment of £50 into a grandchild’s Junior ISA over 18 years would get £10,800 out of your estate, save £4,320 in IHT, and give the lucky recipient an impressive nest egg to kick-start their adult life. Assuming average returns of 5% after charges, your generosity would mean they could end up with a pot worth £17,460.

Topping up an adult child’s pension contributions could be worth considering too – especially if they are struggling to pay in as much as they need. In addition to compounding returns over time, the contribution will be boosted by tax relief, giving you an additional tax win on top of the IHT saving.

The catch – which arguably goes some way in explaining why this particular exemption is so underused – is that that such gifts can come under very close scrutiny from HMRC.

To be declared IHT-free your gifts need to meet the following criteria:

  • Gifts need to form part of your normal expenditure
  • Payments need to come from your income, not your capital
  • Your standard of living must not suffer as a result of you making the gift

Let’s look at each of these points in a bit more detail:

Normal expenditure

As far as HMRC is concerned, normal means regular. It doesn’t have to be weekly, monthly or yearly, but it will expect to see a pattern in your gifts – that is repeated payments going to the same person over a period of time.

Coming from income

You can make gifts from any form of regular income – for example from earnings, a pension or an annuity. You could also use rental income or income payments from an ISA. What you can’t use is money from capital by raiding savings accounts, investment plans or investment bonds to make the gifts.

Standard of living

Finally, HMRC will want to ensure that you can genuinely afford to make the gifts, without your lifestyle taking a hit. Invariably you would have less money in your current account after making the gift, but officials would want to see that you can still afford to live comfortably. Living expenses don’t just include basics such as food and bills, they should also include money you spend on leisure activities such as eating out and hobbies.

Importantly, you can’t try and get around these rules by making gifts out of income but then use your capital to pay for your regular living expenses.

Making sure your gifts qualify

These demands mean that if you want your gifts to be exempt from IHT, the onus is on you to ensure that the executors of your will have all the information they need to satisfy HMRC.

Part of your executor’s duty is to value your estate after you have died and pay any IHT that is owed. As part of that they will need to complete form IHT403 to declare any gifts you have made.

They won’t need to declare gifts that fall within the £3,000 annual allowance or small gifts up £250, but they will need to mention:

  • Gifts you made within seven years of your death
  • Gifts with reservation of benefit (for example, a house that you carried on living in)
  • Gifts from surplus income

To properly complete the gifts from surplus income part of the form, your executors will need comprehensive information about both your income and expenditure. This is to demonstrate that you could afford to make the payments without them having a detrimental effect on your lifestyle.

The income section asks for details of:

  • The tax years gifts were made
  • Income from salary, pensions, interest, investments, and rents and any other sources
  • The amount of income tax you paid
  • Your net income (after tax)

The expenditure section, meanwhile asks for details of:

  • Mortgages
  • Insurance
  • Household bills
  • Council tax
  • Travelling costs
  • Entertainment
  • Holidays
  • Nursing home fees
  • Any other expenses

Your income, less your expenditure, is your surplus income", which also needs to be included on the form. Only if your surplus income is enough to cover the cost of your regular gifts will they qualify for IHT exemption.

This means it is essential you leave your executors detailed information about your gifts, income and expenditure and ensure that they know where to find it when the time comes.

It can also help the process if you write a letter confirming the nature of the payments you are making and your intention that they will be regular.

Start off on the right foot

Providing this evidence is undoubtedly an admin headache. But, if you make your intentions clear from the get-go and are able to keep organised records of your income and expenditure (which you may well be doing anyway for budgeting reasons or to complete your tax return) then it could save your loved ones a fortune when the tax bill comes - not to mention sparing your executors a lot of stress and hassle.

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