How to give away a tax-free inheritance

Financial experts provide readers with advice on how to dodge death duties. By Charlotte Gifford

The “gifts out of surplus income” rules allow taxpayers to pass on unlimited sums to their heirs without paying any inheritance tax. This is an invaluable tax break for those who need to bring down the value of their estates below the taxfree allowance. Inheritance tax is charged at 40pc on estates worth more than £325,000, or £500,000 if the person passes their home on to their children. Married couples and civil partners get a combined allowance of up to £1m.

Each year individuals can give away £ 3,000 without worrying about inheritance tax. They can also gift £5,000 to a child in the year of their wedding or civil partnership, or £2,500 to a grandchild.

But if you want to give away more than this, inheritance tax could be due on the gift if you die within seven years – unless you gift out of surplus income.

To qualify for the exemption, the gifts must form part of a pattern, come out of income – not capital – and should not diminish the donor’s standard of living.

Applying this in practice can be far from straightforward. HM Revenue and Customs has outlined detailed guidance on how its officers should interpret the rules, and these interpretations can sometimes appear bizarre and arbitrary. For example, the tax man will look at the donor’s annual income to work out whether they could afford the gifts – however, income held for more than two years will generally be considered capital.

So it is unsurprising that we receive many questions from readers asking whether they are able to use unlimited gifting in their specific circumstances.

We reached out to several financial advisers, and asked them to answer your questions about this lucrative inheritance tax break.

Bill Tong

Q: My mother is 81 and inherited 100pc of everything when my father died. He left nothing to his sons. She, like many elderly people, has only pension “income”, although probably in excess of £1m in assets. I’m not sure this idea works for her or anyone like her.

Sean McCann Chartered financial planner at NFU Mutual, an insurance firm

A: The exemption can cover income from a wide range of sources including pensions, earnings, dividends from shares, interest from cash deposits and rents. Depending on the assets that make up your mother’s estate, it’s possible that she may be able to take advantage of the exemption.”

Susie Preston

Q: Can I give my son a car through “gifts out of surplus income”?

Rachael Griffin Tax and financial planning expert at investment firm Quilter

A: Gifts out of surplus income are typically expected to be gifts of money, given it must be out of income in order for the exemption to apply. However, purchasing a car may qualify for the exemption if the asset was purchased using income specifically to give to the recipient – in this case, your son – but you must meet all other conditions.

This means the gift must form part of your normal expenditure, it must have been made out of income, and it left you with enough income to maintain your normal standard of living.

If you are looking to use this exemption, it is vital to keep up- to- date, detailed records of any gifts you make, as well as any intended future gifts.

Susan Dee

Q: If you give on a monthly basis and had a large expenditure one month, having to dip into capital, would that break the pattern of gifting? Or would it not matter and you could return to the regular pattern the next month?

Ms Griffin said: A:

The amount of money gifted on a monthly basis is important, as these gifts must be comparable in size. Though small differences are generally OK, if you gift a considerably larger amount then you must be able to provide evidence to show how it fits within your normal gifting pattern.

In some cases, the part of the gift that is treated as the normal gifted amount will be exempt, and the remaining amount above the normal part will not qualify for the exemption. But, if the gift relates to a specific cost, such as grandchildren’s school fees that can naturally vary, then this may also be acceptable.

Gary Lawrence Q:

Do the gift payments also count as a legitimate way to remove money from a local authority care funding assessment? My parents are funding their care privately, and are already below the IHT threshold. But if money can be legitimately gifted it can presumably avoid being used to pay for care costs?

Mr McCann said: A:

The “gifts out of normal expenditure” exemption relates only to inheritance tax. If support is needed to meet care home costs in the future, the local authority will review whether the individual has deliberately deprived themselves of income or capital.

If it is decided that the resident has disposed of income or capital to avoid a charge, or to reduce the charge payable, it is possible that the local authority could transfer the liability to the person to whom the income or capital has been passed.

Martin Cottrell

Q: I see pension is classed as income so exempt, so is that true for the pension 25pc tax-free lump sum if gifted, and you can still pay the bills on current income? Would it have to be split over several years to make it regular?

Ms Griffin said: A:

Assuming the whole pension commencement lump sum was taken at once, it is not possible to avoid other taxes. For example, if the money was held in a bank account and interest was payable, anything that was not exempt because of personal allowances would be subject to income tax.

However, it is possible to make gifts for IHT mitigation. These gifts can be made either to individuals directly, and may be considered potentially exempt transfers, or could utilise allowances such as the £3,000 annual exemption, or the gifts could be put into a trust to be held for minors. However, it is worth noting that if this was a discretionary trust, then the transfer would be a chargeable lifetime transfer.

‘It is vital to keep up-to-date, detailed records of any gifts you make’

Karlos Hockenheimer

Q: Giving away money that is part of one’s income … surely this will have been taxed at the higher rate of income tax and the donor will have to pay this, so it’s not tax-free, or am I missing something?

Ms Griffin said: A:

Yes, any gifts of income to your loved ones may have suffered income tax where applicable.

In addition, while the recipient does not pay tax on a cash gift, they may pay tax on any income that arises from the gift, such as bank interest.