Possibly one of the most generous inheritance tax exemptions available relates to making gifts out of your surplus income. There is no upper limit to the amount which can potentially be given away tax-free, within the bounds of your own income and subject to your own regular spending requirements. If gifts of this type are documented correctly and fit HMRC’s criteria, they are immediately exempt from inheritance tax, and there is no need for the donor to survive for 7 years. This type of gift will also not use up your inheritance tax free nil rate band on death.
Who should make gifts out of surplus income?
The exemption is probably most useful to someone at a stage of life when they are in a senior role and generating a lot of income, but with fewer financial commitments than they have had in the past, perhaps with the children now financially independent and the mortgage a thing of the past. In that scenario, which usually goes hand in hand with a prospective inheritance tax problem, it is possible to remove a lot of value from an estate very tax-efficiently by this method.
What are the rules for making gifts out of surplus income?
For a start, the income that you give away must be truly excess. There should be a pattern of regular giving (making regular gifts 3 times, with a documented intention to continue, is a great start), and the gifts should be part of your ‘normal expenditure’. They must be made out of income and not capital, and they must leave you with enough income to maintain your usual standard of living.
What records must I keep, and how much can I give away?
The bad news is that some mildly onerous record-keeping is required in order to satisfy HMRC that the gifts were truly made out of surplus income. Questions may well be asked, and forewarned is forearmed. This involves setting out your annual income and expenditure in a degree of detail. By far the best way to record your gifts is to fill in the form that will be needed before applying for probate after your death, as you go along. The final page of inheritance tax form IHT403, which you can find online here, is the one to use. It is also important for the person making the gifts to write a letter setting out details of their intention to make regular gifts out of income to a certain beneficiary (perhaps until such time as they retire, if applicable).
As a rule of thumb, it has been suggested that the Capital Taxes Office is unlikely to query the validity of gifts out of income as long as they don’t exceed one third of the donor’s net income after tax. Unfortunately, the only point at which it becomes certain that gifts out of income have been successfully accepted as such by HMRC is after the transferor’s death, hence the importance of impeccable record keeping.
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