One of the most overlooked
Inheritance Tax exemptions
Inheritance tax is one of those subjects that has a habit of generating more headlines than understanding. Every Budget seems to bring speculation about who will pay more, which reliefs might disappear and how families should respond.
Yet some of the most useful tax reliefs receive comparatively little attention.
One example is the exemption for gifts made out of surplus income. It is not especially well known, but for the right person it can be one of the most effective ways of passing wealth on to the next generation.
Unlike many gifts, which generally need the donor to survive for seven years before they fall outside the estate for inheritance tax purposes, qualifying gifts from surplus income can be exempt immediately.
That sounds almost too good to be true but there is an important caveat: the rules need to be followed carefully and good record keeping is essential.
In this article:
⏵
More than simply giving
money away
⏵ Why many claims fail
⏵ Good record keeping is vital
⏵ Why this is becoming increasingly relevant
⏵ Planning ahead
More than simply giving money away
The exemption was introduced because Parliament recognised that it seemed unfair for someone to pay income tax on money they never intended to spend, only for that same money potentially to become liable for inheritance tax later on simply because it had accumulated over time.
The legislation therefore allows people to pass on genuine surplus income during their lifetime, provided certain conditions are met.
Broadly speaking, the gifts must:
- come from income rather than capital;
- form part of a regular pattern of giving;
- leave you with sufficient income to maintain your normal standard of living.
Those conditions are important. This isn’t simply a case of making a large one-off payment to a child or grandchild whenever you happen to have spare cash. The exemption is intended for people who have income they genuinely do not need and who wish to make regular gifts from it.
For some, this might mean helping adult children with childcare costs or mortgage payments. Others may wish to assist grandchildren with university expenses or make regular contributions into savings or investment accounts on their behalf.
Why many claims fail
Perhaps the biggest surprise is that many claims fail not because the gifts themselves were inappropriate, but because there isn’t enough evidence to demonstrate that the conditions were satisfied.
By the time inheritance tax is assessed, the person making the gifts has often passed away. It falls to their executors to demonstrate that the gifts qualified for the exemption.
That can be surprisingly difficult. Executors may have to reconstruct years of financial information from old bank statements, pension records and tax returns. If clear records haven’t been kept, proving that gifts came from surplus income rather than capital can become challenging.
Equally, it may be difficult to demonstrate that the donor maintained their normal standard of living after making the gifts, or that the gifts formed part of an established pattern rather than being isolated transfers.
In other words, HMRC is often not disputing that the gifts were made. The difficulty is proving that they met the conditions laid down in the legislation.
Good record keeping is vital
This is why documentation matters. Keeping a record of your income, your regular expenditure and any gifts you make each year can make life considerably easier for your family in the future.
It also allows your financial plan to be reviewed regularly. Circumstances change. Income rises and falls, expenditure changes over time and what counted as surplus income five years ago may no longer be surplus today.
A strategy that is reviewed periodically is generally much more robust than one that is put in place and forgotten about.
Why this is becoming increasingly relevant
Many families are reviewing their inheritance tax planning as tax rules continue to evolve. In particular, forthcoming changes to the treatment of pensions for IHT purposes mean that more people are considering whether passing wealth on during their lifetime may be better than leaving larger estates behind.
For some, drawing income that they do not need and gifting it in a structured way could prove considerably more tax-efficient than allowing those funds simply to accumulate.
This approach is not suitable for everyone. Much depends on your overall financial position, the nature of your income and your future spending requirements.
The important point is that there are legitimate planning opportunities available, but they need to be approached carefully.
Planning ahead
As with many areas of financial planning, the principle is often simpler than the practical application.
The challenge is rarely making the gift itself. It is ensuring that the gifts are structured correctly, remain affordable over time and are supported by the evidence HMRC may require many years later.
That is why professional advice can be so valuable. A regular review provides an opportunity not only to assess whether gifts remain appropriate, but also to ensure that the necessary records are being maintained.
If you have surplus income that you are unlikely to need and would like to explore whether this exemption could form part of your wider financial planning, we would be happy to discuss your circumstances and help you put the appropriate arrangements in place.
