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Could the obscure “gifts from income” rule help you mitigate Inheritance Tax?

Category: Blog
A man writing a cheque

Inheritance Tax (IHT) is a contentious issue right now and there have been rumours that the government is considering changing or even abolishing the tax altogether.

This may be a popular position with many people because the number of families paying IHT has risen in recent years, and this trend could well continue in the future.

Fortunately, there are several ways to potentially mitigate a large IHT bill and pass more of your wealth to your loved ones. For example, lifetime gifting can be an effective way to reduce the size of your estate for IHT purposes.

Yet, there is a little-known “gifts from income” rule that you may be overlooking. Indeed, according to the Telegraph, only 430 families made use of this in 2022. This is despite the fact that it could be particularly beneficial during the cost of living crisis when loved ones might need regular financial support.

Read on to learn how the gifts from income rule could potentially help you mitigate IHT.

The IHT “nil-rate bands” are frozen until 2028

In the 2023/24 tax year, you can pass on up to £325,000 to your beneficiaries without triggering an IHT charge. This is known as your “nil-rate band”. You may also benefit from a £175,000 “residence nil-rate band” when passing on your main home to a direct descendant, such as a child or grandchild.

This means you can potentially pass on up to £500,000 tax-free. Additionally, you can pass your entire estate to your spouse or civil partner without IHT, and they can inherit your unused nil-rate bands. As a result, you may be able to pass on up to £1 million between you without your loved ones facing an IHT charge.

Despite this, the amount of IHT that families pay is on the rise. According to UK government figures, IHT receipts reached £7.1 billion in the 2022/23 tax year – an increase of £1 billion on the previous year.

This is likely because the nil-rate bands have been frozen since April 2009 and will remain so until at least April 2028.

Meanwhile, the value of your estate may increase over time as house prices rise and you potentially see growth on your savings and investments. As a result, you could be more likely to exceed your nil-rate bands, meaning that your family pays more IHT.

You have a £3,000 IHT gifting annual exemption in 2023/24

Gifting wealth to your beneficiaries while you are alive can be an effective way to reduce the size of your estate for IHT purposes. This is because those gifts might no longer be considered part of your estate, provided they meet certain criteria.

As a result, this could help you and your family mitigate IHT because a smaller percentage of your estate exceeds the nil-rate bands.

Yet, there are specific rules about how gifts are treated after your death. In the 2023/24 tax year, you have a £3,000 IHT gifting annual exemption. This means that any gifts up to a total of £3,000 (or £6,000 as a couple) immediately fall outside your estate.

You can also make small gifts of up to £250 per person, to as many people as you like, provided you have not used any other gifting exemption on them. Further to this, you can gift an additional £5,000 to a child or £2,500 to a grandchild for a wedding or civil partnership.

Any further gifts are considered “potentially exempt transfers” and only fall outside your estate if you survive for seven years after giving the gift. If you die before this, your family will likely still pay IHT on those funds.

Fortunately, the “gifts from income” rule may allow you to make unlimited gifts, which are automatically considered exempt from IHT.

Gifts that are part of your “normal expenditure” are not subject to the 7-year rule

The gifts from income rule allows you to make regular payments to a beneficiary and they fall outside your estate right away. Unlike other gifts, they are not subject to the seven-year rule.

However, the payments must meet certain criteria to qualify for the gifts from income exemption. The payments must:

  • Be regular
  • Come from income rather than capital
  • Not diminish your standard of living.

For a gift to be considered part of your “normal expenditure”, there must be a pattern of payments over an extended period of time. Each case is assessed separately, but HMRC typically looks back over the past three or four years to see how often you made the payments.

As such, a single payment or a few sporadic payments likely won’t qualify for this exemption and may still be subject to the seven-year rule.

Ideally, the gifts should be of a similar size but if they relate to a specific expense, such as school fees, variable gifts might be acceptable.

You must also make payments from your regular income – this may include your salary, pension income, or dividends.

Finally, the payments can’t diminish your current standard of living. Your standard of living can be difficult to define, but HMRC may look at your income and outgoings to see whether the gifts affect your ability to pay other regular expenses.

Regular gifts could support your family during the cost of living crisis

The cost of living crisis is putting pressure on many people’s finances. As a result, you might be looking for ways to support your family members.

According to Royal London, in March 2023, financial advisers reported that 25% of recent requests were from clients wanting to release funds for their adult children. Additionally, 55% of people were more concerned about their family’s financial situation than their own.

If you want to support your family, making regular gifts from income could be an effective way to help them cover increased living costs.

Alternatively, you could make regular third-party contributions to their pension. This may help them continue working towards their long-term goals, even when their outgoings increase during the cost of living crisis.

The executor of your will may need detailed records of the gifts to claim the exemption

When you pass away and the executor of your will deals with your estate, they will have to calculate whether any IHT is payable.

It is up to them to claim the gifts from income exemption on the regular gifts you make. That’s why it’s important to keep detailed records of any payments.

If possible, keep a record of how much the payments were for, what dates they were made on, and where they came from.

Get in touch

If you would like to explore the gifts from income exemption, and any other options for mitigating IHT, we are here to help.

Please get in touch to find out how our team of VouchedFor Top Rated planners could help today.

Please note

This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.

The Financial Conduct Authority does not regulate estate planning, tax planning or will writing.

A pension is a long-term investment not normally accessible until 55 (57 from April 2028). The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Past performance is not a reliable indicator of future results.

The tax implications of pension withdrawals will be based on your individual circumstances. Thresholds, percentage rates and tax legislation may change in subsequent Finance Acts.

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