Recently, we’ve been focusing on the importance of estate planning. This topic is front of mind for many following the changes to inheritance tax (IHT) announced in the Autumn Budget. In particular, the proposed changes with regards to pensions and Inheritance Tax have caused concern for some. If you have worked hard in your lifetime to build a legacy, the thought of handing over 40% of it to the tax man upon your death probably feels rather galling.

Despite the changes, there are still many ways to pass on your wealth tax efficiently. One of these is by gifting out of your income during your lifetime, rather than waiting to pass it on after your death. It’s a highly effective way to pass your wealth onto your loved ones. However there are a few rules and tips to keep in mind.

 

How does it work?

If you have surplus income that you don’t need for your day-to-day expenses, you can give it away tax-free. These gifts made out of your income are exempt from IHT, without the need to wait the usual seven years for them to leave your estate. As you would expect, there are certain rules that apply to gifting out of income.

Firstly, the gift must be made out of your income, rather than being funded from your capital. It needs to be part of a regular pattern of giving, such as a monthly or annual payment, rather than just a one-off here and there. One-off gifts would be subject to the seven year rule.

Secondly, after the gift is made, you must be left with enough income to maintain your normal standard of living. If you gift yourself into hardship, it’s likely to be flagged by HMRC as a set of abnormal transactions.

It is highly advisable to document the gifts well. You should be able to demonstrate that they are gifts from income in the event of your estate being contested by HMRC. You’ll need to clearly document your income, expenses, and the gifts made. Show a pattern of regular gifting and maintain evidence that your standard of living is unaffected.

By meeting these criteria, the gifts reduce the value of your estate for IHT purposes without using up your annual exemptions or seven-year rule thresholds.

 

How could this look in practice?

Imagine you have an annual after-tax income of £100,000 and annual living expenses of £60,000, leaving a surplus of £40,000. You could gift part or all of this £40,000 each year to family members. If properly documented, these gifts would immediately fall outside your estate for IHT purposes. This saves you 40% IHT on the gifted amount.

 

Benefits of gifting out of income

This method has five key advantages:

  1. Unlike larger lifetime gifts (which may be subject to the seven-year rule), regular gifts out of income are immediately exempt from IHT.
  2. There’s no upper limit to the amount you can give, so long as it satisfies the rules in the section above.
  3. You can combine gifts out of income with other exemptions. These include the annual gift exemption (£3,000 per year) or small gift exemption (£250 per person per year). This allows you to maximise the amount you can gift tax-free.
  4. The value of your estate will reduce. This may help to bring it below the IHT threshold.
  5. Since the gifts are made during your lifetime, you have the pleasure of seeing it put to good use. You may even be able to provide a guiding hand to help your beneficiaries manage the funds.

 

What next?

Gifting out of income can be a really smart way to reduce your inheritance tax liability whilst still passing on the wealth to your intended beneficiaries. However, you should consult your financial planner before making any changes or rearranging your income to allow for this.

Not sure if you can afford to gift away? Your financial planner can run a cashflow model to map out the scenarios available to you.

Get in touch with us on info@wealth-matters.co.uk or 01582 720 511 if you would like to talk about including gifts out of income in your estate planning.