As Chancellor Rachel Reeves sets out plans to grab a bigger chunk of people’s wealth when they pass away, one little-known trick has escaped her gaze.
It allows you to pass on unlimited wealth free of inheritance tax.
It doesn’t require complex trusts or bonds, expensive advice or admin. Unlike most other gifts, you don’t have to survive for seven years after making it for it to be free of inheritance tax.
In fact, all you need to set it up is a letter. Put your mind to it and you could have it sorted by teatime today.
The exemption is known as gifting out of surplus income. In other words, you can pass on as much money as you like, so long as it comes from your income rather than existing assets.
As Chancellor Rachel Reeves sets out plans to grab a bigger chunk of people’s wealth when they pass away, one little-known trick has escaped her gaze
Gifts from regular, surplus income are tax-free and won’t later incur a bill.
This way of gifting could become even more precious as the Chancellor confirmed yesterday that VAT will be added to private school fees in January.
It allows grandparents to pay for fees out of their income, knowing their families won’t face an inheritance tax bill on the payments should they not survive for seven years.
Ian Dyall, head of estate planning at wealth manager Evelyn Partners, says it is a ‘little-known, but fantastic way of passing on wealth tax-free’.
‘When people first hear about it, they often think it sounds too good to be true,’ he adds.
How much can you give?
You can make gifts as big or as small as you like – and to whomever you like – so long as you make them out of your income.
Julia Rosenbloom, a tax specialist at Shakespeare Martineau, says she sees gifts made in this way ranging from a couple of thousand to half a million pounds every year.
You can make gifts as big or as small as you like – and to whomever you like – so long as you make them out of your income
‘It can be a good way for grandparents to pay towards school or university fees,’ she says. ‘Or just for gifts on birthdays. The gifts must be regular.’
Rosenbloom adds that gifting in this way can be a great way to ensure your inheritance tax liability does not grow higher. By gifting some of your income, you prevent it from adding to your existing assets.
James Ward, a partner at law firm Kingsley Napley, says he often sees the exemption used to help get children on the property ladder or who are struggling financially.
What can you gift?
You can gift anything, so long as it counts as income. That could include giving from your salary; an income from buy-to-let properties; dividends if you own your own firm; or income from your investment portfolio.
Gifting interest from savings is an increasingly useful way of passing on income, says Sean McCann of wealth manager NFU Mutual. ‘As interest rates have risen, many older people are seeing impressive returns on their cash deposits,’ he says. ‘This gives them more scope to give money away.’ You do not need to gift all of your excess income. If you don’t want to hand over the money straight away, you could make regular gifts into a trust to be distributed at a later date. A tax adviser can help you set one up.
Are there any rules?
In order to qualify for the exemption, the gift must fulfil three criteria.
First, it must come from income, rather than capital. Once you have held on to your income for a couple of years, the taxman starts to treat it as capital, so you will need to make the gift within that time frame. Second, it doesn’t matter how often you make a gift – whether it’s monthly or yearly, for example – so long as it follows a regular pattern.
Third, gifts should not affect your everyday standard of living.
For example, if you are someone who regularly goes on worldwide luxury cruises, but stop when you start giving large sums to family members, HM Revenue & Customs (HMRC) may not accept that you are gifting out of surplus income.
If you live more frugally, but stop spending so much on nice groceries when you start making gifts, HMRC will be equally suspicious.
How do you make the gift?
You must record your intention to gift regularly. This does not need to be in the form of a legal document. You could send a letter to the recipient – and file a copy for yourself – telling them that you have decided to make them regular gifts.
To be extra safe, you may want to mention in the letter that you plan to make the gifts as you have income you don’t need yourself.
Although you don’t need to fill out any forms, Faye Church, at wealth manager Investec, recommends completing one just to make life easier for your executors.
On your death, they will have to complete a form called IHT 403 to show that the gifts qualify for this exemption. It details your income, expenditure and gifts made.
‘If the information is already pre-populated on the correct forms, they don’t have to trawl your records,’ says Church.
Gifts must come from income, rather than capital. Once you have held on to your income for a couple of years, the taxman starts to treat it as capital, so you will need to make the gift within that timeframe
‘They may also not know that it was your intention to use this exemption, so at the least write it down and keep it somewhere safe, preferably with your will.’
The exemption can be used retrospectively for someone, even if it wasn’t their intention. ‘Some people don’t use the exemption in their lifetime because they are unaware of it,’ says Ward.
‘If the executors see they made regular gifts that would be liable for inheritance tax, they could retrospectively piece together their income and expenditure to show it met the rules.’
Gifts made need to be ‘regular’, according to HMRC. But as there is no legal definition of ‘regular’ in this case, the dictionary definition can be used.
If your income varies, you do not need to make the same size gift every time, but you do need to show patterns in giving.
For example, always gifting your work bonuses, savings income or making a regular gift at Christmas or on birthdays.
Watch out for the pitfalls…
You can’t simply gift your income and live on your capital – HMRC will see through it.
Not all investment income qualifies for the exemption.
Faye Church explains: ‘Insurance policies, lump sum cash payments or the capital element of life annuities is seen as a capital repayment rather than an income receipt.’
If you are gifting from investment income, check it is eligible so you’re not caught out.
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