How to reduce inheritance tax.
Inheritance Tax (IHT) is a tax paid when you die, on the value of the assets you own such as your home, possessions and money. I know it sounds unfair…
The rate of IHT is 40% on the part of your estate above the tax-free threshold, currently £325,000. This threshold has been stuck since 2009 and not intended to increase until at least 2028 (unless whoever is in Parliament come 5th July has any changes in mind).
There are lots of reliefs and exemptions available to help mitigate the burden. I was told recently that IHT has the highest number of reliefs of all the UK taxes but have yet to sit down to work out if this is true. Perhaps when that sock drawer is finally in good order, I might move onto counting these.
A lot of clients come to me to find out how they can reduce their estate to avoid IHT and there is a simple short answer:
- Irrevocably give assets away (so that you no longer receive any benefit whatsoever) and
- Survive for 7 years after you have given them away (or the value comes back into your estate like a former relationship returning to make your life hell once more).
Point 1 is easier to manage than Point 2, as few of us know exactly when the Grim Reaper might come calling. However, it’s good to know that there’s a really valuable exemption which applies to lifetime gifts made out of your surplus income.
These gifts can be any size as long as they meet the qualifying conditions and are immediately exempt from IHT, so no need to survive 7 years for these assets to leave your estate.
The qualifying conditions in order for the exemption to apply are as follows:
The gift must be made from income Â
Gifts made out of capital do not qualify and it will be necessary to demonstrate that the gifts were made from net (post-tax) income. Income generally means your salary, savings interest, dividends and pension. You can’t live off capital and gift income, you have to be able to show that after your normal living expenses there is sufficient income left to gift.
HMRC considers income to be from that specific tax year, although some pretty limited carrying over from year to year is allowed.
However, the exemption will not apply to gifts made from income which has been accumulated over several years. In these cases, HMRC will consider your pile of accumulated income has changed and now acquired the nature of capital.
The gift must be made from surplus income Â
After making the gifts, you must be left with enough income to maintain your usual standard of living. This means that if you normally shell out on 3 holidays a year to Barbados and are now reduced to a rainy week in Skegness (apologies to any residents of Skegness) in order to make the gifts they will not be exempt.
As noted above, gifts will not qualify for the exemption if you have to resort to capital to meet your living expenses (so selling your prized vinyl collection to release funds will not work).
The gift must form part of the normal expenditure of the donor Â
‘Normal’ means what is ordinary for you and this isn’t the same for everyone.
‘Normal’ also means ‘habitual’ or recurring, and so you must establish a regular pattern of gifts to demonstrate that the expenditure is ‘normal’. One-off gifts or gifts for a special purpose will not qualify.
There’s no set time span to indicate a habit of giving but a reasonable length of time would be 3/4 years. There is also no set period for how regularly the gifts must be made; they could be monthly, quarterly, yearly or even every other year, as long as a pattern can be demonstrated.
The gifts should be comparable in size or proportionate to each other and to the amount of surplus income for the relevant tax year.
The exemption is only available if the necessary conditions are met. The exemption must be claimed; it is not given automatically. In order to claim the relief your executors have to provide a lot of detail on annual income/outgoings and gifts in order to claim, so record keeping is absolutely key. If the relief is to be claimed, you should monitor your income and outgoings and surplus income for each tax year as well as all gifts, as you never know when you might need it.
In summary, where circumstances permit, and bearing in mind for many people as they get older their income requirements tend to naturally fall, this can enable potentially large sums to be given away with an immediately effective IHT exemption.
If you have any questions around gifts and IHT planning, and how to reduce inheritance tax, please contact Anthony by completing the form below.
Anthony can also offer advice on the subject of tax on investment bonds following a death. Find out more here.Â
