Reducing your Inheritance Tax Bill: Gifts from Income
Written by: Richard Mead, Senior Associate – Inheritance Protection Team
Most people with an interest in Inheritance Tax are aware that they can give away up to £3,000 per year without any Inheritance Tax (“IHT”) consequences. They also know that a larger gift is usually exempt from IHT if you live for at least 7 years after making it.
However, there is another very valuable IHT exemption which is less well known. This is the “normal expenditure out of income” exemption. In very general terms, regular gifts out of an individual’s surplus income are completely exempt from IHT as soon as they are made. There is no requirement to survive 7 years in order for the exemption to apply. In the right circumstances there can be scope to quickly achieve substantial IHT savings.
Income for these purposes includes non-taxable income from ISA accounts and investments but does not include regular withdrawals from investment bonds.
For the exemption to be available you must have surplus income after all regular expenditure has been deducted (for example household expenses, the costs of running a car, holidays, care fees and Income Tax). A frugal individual with an annual income of £50,000 could have more surplus income than someone earning £100,000 a year who lives a lavish lifestyle. In order for the exemption to apply there must be a pattern of regular gifts so this exemption won’t help if you can only commit to occasional gifts.
HM Revenue & Customs (“HMRC”) do understand that some people have a fluctuating income. They will look at the pattern of income and expenditure over several years to decide whether the exemption should be granted.
A grandparent with surplus income could utilise the exemption by paying school fees for grandchildren. As long as there is sufficient surplus income to cover the fees it does not matter that the amount due each term is different. Surprisingly, there is no limit on the amount of exemption that can be claimed.
All that matters is that the gifts must continue for a reasonable period of time (typically several years). After the gifts have been made the donor must be left with sufficient income to maintain his or her usual standard of living.
A parent with two adult children and annual surplus income of £12,000 could make monthly contributions of £500 into an ISA account for each child. If the parent died after 5 years there would be an IHT saving of up to £24,000 (40% of £60,000). It is worth noting that the £3,000 annual exemption can be claimed on top of the normal expenditure exemption.
There is no requirement to notify HMRC when gifts from income are made. However, after you have died your executors will have to formally claim the exemption for each of the 7 tax years up to your death. It is therefore vital to keep accurate records of income, expenditure and regular gifts. If not, it may be an almost impossible task for the executors to try and compile this information retrospectively.
HMRC do not grant the exemption lightly as often a considerable amount of IHT is at stake. The relevant information should ideally be recorded on the HMRC form which the executors will eventually have to complete. However, records only have to be retained for 7 years. After that the gifts are exempt in any event.
Spouses and partners should remember that they are treated individually for tax purposes. It is therefore important for each of them to keep a separate record of income and expenditure. Gifts should ideally be made from individual accounts rather than a joint account.
Sometimes an individual intends to make regular gifts but dies after one or two payments. In these circumstances HMRC will still allow the claim if there is evidence of an intention to make regular gifts. It is therefore a good idea to record this intention in a letter or statement when the first gift is made.
The normal expenditure out of income exemption should always be considered at an early stage if you are in a position to make lifetime gifts. Over a number of years the exemption can provide a very tax efficient method of transferring significant funds completely free of IHT. For those individuals with substantial wealth the normal expenditure exemption can of course be used alongside gifts of capital (the latter are subject to the 7 year rule).