Gifting out of surplus income to reduce inheritance tax

In this article, we look at the benefits of gifting your surplus income to family members.

Making IHT gifts from surplus income 

If you are considering making gifts from your excess income, you need to show that you intend to continue these regularly, without affecting your normal standard of living, using your income, not your capital.

There are a number of different ways you can do this, which we have outlined in this article. If you would like specific advice on your personal situation, get in touch.

Use your excess income to buy a life assurance policy

If you have surplus income, you could consider using it to invest in a ‘whole of life’ policy, which is paid out on death and can provide a means to pay some of your estate’s inheritance tax bill.

In the example below, we explain how our independent Wealth Planners have set up an inheritance tax plan using this approach to manage how much IHT our client’s family will have to pay.

Josephine, a widow aged 65, has substantial assets - and a large part of her estate will likely be subject to IHT. She is not concerned with negating the entire IHT bill but wants to leave certain high-value items to her children.

Josephine wants to ensure a lump sum is available to her beneficiaries before probate is granted so that the high-value items won’t need to be sold to pay IHT. She has excess income each month and expects this to be the case for the rest of her life.

Josephine's Wealth Planner helps her to invest £40,000 per annum in a £2m ‘whole of life’ policy. This policy is medically underwritten and ensures that, as long as the premiums continue to be paid, the policy will pay out the sum assured on her death. It's written into trust, so the proceeds won't form part of her estate and the funds will be paid to the trust beneficiaries (currently her children) before probate is granted. The policy premiums, which are purchasing a benefit for others, will not be subject to IHT as they would be from her excess income.

If you would like to discuss your personal situation with one of our IHT specialists, request a consultation.

Paying for school fees as a gift from excess income

In this example, our Wealth Planner initially suggested that our client’s excess income could be used to pay for their grandchildren’s school fees in order to manage their future inheritance tax liability.

Henry and Lily are both retired with generous final salary scheme pensions, plus investment portfolios and a savings account. They are now finding themselves with excess income each month.

Rather than let excess income build up in their estate and potentially create a future IHT liability, Henry and Lily want to make regular gifts to help pay for their twin grandchildren's school fees. They write a formal letter to their daughter Alice (the mother of the twins) informing her of their intention to make the gift on a regular basis. They also keep a record of their ongoing income and expenditure, to demonstrate that the gift is being made out of surplus income.

After six years of making the regular gifts, Henry needs funds for private medical care and the regular gifting is no longer affordable. If circumstances change and gifting stops, the exempt status of gifts made previously does not change, as long as they have already qualified. 

Other ways of using surplus income as consistent gifting

Making regular gifts out of excess income can be a useful way to prevent further increases in your estate's taxable value. As well as funding ‘whole of life’ policies or school fees, you could simply use regular gifts to fund:

• Pension contributions for adults or minors
• Building up ISA or JISA subscriptions
• Sending the family on regular holidays every year.

What are the conditions for gifting money to family?

If family or other beneficiaries wish to claim the gifting exemption, it will need to be claimed by the executors after the death of the donor, and it must be shown that the gifting meets three conditions:

• There is clear evidence of an intention to make regular gifts out of normal expenditure
• The gift was made out of net income and not a transfer of capital assets; common sources are employment, rent from property, pension income, interest, and dividends
• The donor must be left with enough income to maintain their current standard of living, so they don't need to resort to capital to meet their needs. 

Keeping good records is the key to making a simple and successful claim for the exemption. Form IHT403 requires the details of annual income and expenditure in each year gifts were made. An annual record-keeping exercise, which your accountant can help with, will make the process much easier than trying to backdate records later.

Anything more substantial may be subject to tax if you don’t survive seven years after making the gift. However, many people are unfamiliar with gifting as part of their ‘normal expenditure’ i.e., giving away money from surplus income. This has the added benefit that you’re not giving away large capital sums that could provide you with ongoing income.

What’s next?

IHT rules are complicated and constantly changing. Your Wealth Planner can help you make sure your financial arrangements are up-to-date and take account of the latest legislation.

If you would like to know more about how we can help with your IHT and wealth planning needs, get in touch for a free consultation. We’ll be delighted to answer your questions and provide details of our services.

• Inheritance tax planning service
• Calculating inheritance tax with our simple IHT calculator

The tax treatment of all investments depends upon individual circumstances and the levels and bases of taxation may change in the future. Investors should discuss their financial arrangements with their own tax adviser before investing.

The tax treatments set out in this communication are based on our current understanding of UK legislation. It is a broad summary and cannot cover every circumstance and it does not constitute advice.