Making gifts from surplus income. Is this an option for your estate plan?

Making gifts from surplus income can be an extremely useful inheritance tax (IHT) saving option if applied and documented correctly. However, it is not as widely used as it could be. The Telegraph reports that in 2023, just 270 estates claimed this exemption. From these claims, £27 million was shielded from IHT, amounting to approximately £100,000 per claimant.¹ This option is clearly one not to be immediately disregarded and could be one to consider over the coming months.

* Please note, these changes have not been legislated yet and are therefore subject to change. Any action taken prior to legislation runs the risk that the stated proposals may not in fact come into effect.

Before defining surplus income, it’s important to consider what HMRC class as income for the purposes of this exemption. Income is defined as earnings from:

• Salary from employment/self-employment
• Pensions
• Interest (including from ISAs)
• Investments
• Dividends
• Rental properties

It’s also important to consider what is not classed as income and this is somewhat of a confusing area. Although bond withdrawals are taxed as income, they are not actually income. Any money that comes from a bond is capital. Purchased life annuities (annuities that were not purchased with pension funds) also cause issues because only part of the annuity is classified as income. The remainder is a return of your invested capital.

Once you have established your overall income, the excess, or surplus, can be calculated. As the name suggests, the surplus is any remaining amount after your outgoings have been paid. Outgoings include mortgages, bills, holidays and care home fees to name a few. 

When making gifts from your excess income, the first thing to note is that HMRC are very clear that in order for this exemption to apply on your death, they should not impact your standard of living. If you regularly go on luxury, long-haul holidays, you should not stop these in order to give away more of your income. If HMRC can see a change in this pattern, they may charge your recipients IHT on the gift on your death.

In terms of the gifts themselves, they must be regular in their amount and frequency of payment. It’s important that the gifts are seen as a part of your normal expenditure, as this is often where HMRC will challenge the application for the exemption following your death. HMRC are essentially looking for an identifiable pattern of gifts that look similar over a timeframe of at least three to four years.

One of the easiest ways to do this is to set up a direct debit to the recipient and a bank statement can be presented to HMRC. There are some instances where the amount is changeable, for example, if you pay for your grandchild’s school fees which are subject to regular increases. HMRC do understand that the amounts payable for something like this fluctuate.

It’s important to document the gifts you make accurately and to note your long-term intentions. The simplest way to log any money you give away is by using HMRCs Gifts and other transfers of value - schedule IHT 403 form. You can note your intent to make a regular gift by writing a letter or email to the recipient. While death isn’t the most pleasant thing to think about, noting your intent is particularly important if you were to sadly die after only the first payment is made. If there is clear evidence that the gift was intended to be the first in a regular pattern of gifts, HMRC should apply the exemption. A letter outlining your intentions will help to demonstrate your intent. Otherwise, it could be treated as a one-off payment that would be subject to standard IHT rules.

This allowance could be suitable for anyone who has the relevant excess income and:

• Is expected to have an estate valued at more than the nil rate band (NRB). This is currently £325,000 and it is frozen at this rate until 2030
• Has already made or anticipates making gifts in excess of their annual gifting allowance. This is £3,000 a year. Any unused allowance can also be carried forward one tax year, giving you an increased limit of up to £6,000

The most apparent benefit of making gifts from your excess income is that the size of your estate, and therefore your IHT bill, is likely to be significantly reduced, depending upon the size and frequency of the sums gifted.

By giving away your surplus income, you will also get to see your loved ones benefit from your gift during your lifetime. Your loved one will get the financial support at a time when they really need it. Given current mortgage rates along with the recent addition of VAT to school fees, we have seen a number of clients with adult children in their thirties or forties who need help now, not many years in the future.

Another advantage of making these gifts is that they can be stopped at any point. During a period of much uncertainty around the changes to pensions, IHT, business relief (BR), and agricultural relief (AR), you can still make the gifts from excess income while the rules and regulations are being firmed up, but stop if it doesn’t continue to be financially advantageous over the next 12 months and beyond. This flexibility is also useful if you find yourself in a position where your expenditure grows. Unlike a lump sum payment that you cannot force to be repaid, you can stop any regular payments immediately.

Making gifts from surplus income is potentially a great way to mitigate your IHT liability when rethinking your estate planning options. However, you should not make this commitment lightly and without seeking professional advice. For more information, please speak to your usual Evelyn Partners contact.

Source

¹The Telegraph, The £27m inheritance tax break that families could be missing out on, December 2024