If you're looking to reduce the impact of inheritance tax (IHT) on your estate, one often-overlooked strategy is to give away surplus income during your lifetime. This approach can be particularly effective because, under UK tax law, gifts made from surplus income can be exempt from inheritance tax, provided certain conditions are met. In this blog post, we’ll explore how you can use this strategy, the rules you need to follow, and how to ensure that your gifts qualify for the exemption.
What is Surplus Income?
Surplus income is the money left over after you've met your usual living expenses. It represents the part of your income that is not needed for daily living costs, such as mortgage or rent payments, utility bills, groceries, and other regular outgoings. The key to leveraging surplus income for IHT purposes is that it must genuinely be surplus to your needs—you cannot compromise your standard of living by making these gifts.
How Does Gifting Surplus Income Work?
Gifting from surplus income is considered a form of "regular gifting," which can potentially be exempt from IHT. This exemption is particularly advantageous because it allows for immediate exemption from inheritance tax without the need for a waiting period, unlike potentially exempt transfers (PETs). Here’s how it works:
Identify Surplus Income: Determine what portion of your income is genuinely surplus to your needs. This might include income from pensions, investments, dividends, or any other regular sources.
Make Regular Gifts: To qualify for the exemption, the gifts should be regular and form part of your normal expenditure. This means establishing a consistent pattern of giving, typically annually or more frequently. The gifts should not affect your usual standard of living.
Ensure Gifts are from Income, Not Capital: The gifts must be made from your current income, ideally within the same tax year, although some carryover of income from year to year is permitted. It's important that these gifts come from surplus income rather than accumulated capital.
Keep Detailed Records: Maintain thorough records of your income, expenses, and the gifts made. This documentation will be essential for your executors to make the appropriate claim for the exemption upon your death. The records should clearly demonstrate that the gifts were made from surplus income and not from accumulated capital.
Consider the Type of Gifts: While cash gifts are the most straightforward, other assets can also qualify for this exemption, provided they were purchased specifically from surplus income with the intention of making the gift. However, proving that non-cash gifts meet the criteria can be more challenging, so careful documentation is required.
What Are the Rules for the Surplus Income Exemption?
To ensure your gifts are exempt from inheritance tax, there are several key rules to follow:
Gifts Must Be Regular and Habitual: HMRC looks for a pattern or habit of gifting. This means that a single, large gift may not qualify, whereas smaller, regular gifts are more likely to be exempt.
Gifts Must Not Affect Your Standard of Living: You must be able to maintain your usual standard of living after making these gifts. If the gifts reduce your ability to pay for your living expenses, they won't be considered "normal expenditure out of income."
Gifts Must Be Made from Income: The funds used for gifting must come from your income, not from the sale of assets or capital.
Documentation is Essential: You must keep detailed records of your income, expenditure, and gifts. This includes keeping copies of bank statements, gift records, and proof of regularity. HMRC will ask for this documentation to verify that the gifts meet the criteria.
What Happens If the Rules Are Not Followed?
If HMRC determines that the gifts do not qualify as regular gifts from surplus income, they may be added back into your estate for IHT calculation purposes. This could result in a higher inheritance tax bill for your beneficiaries.
Additional Considerations
While gifting from surplus income can be a highly effective way to reduce your IHT liability, there are a few additional points to consider:
Annual Gift Allowance: Remember that everyone has an annual exemption of £3,000 that they can gift without it being added to their estate. This is separate from the surplus income exemption.
Potentially Exempt Transfers (PETs): Larger, one-off gifts may fall under PETs, which are free from IHT if you live for seven years after making them. However, these do not qualify as gifts from surplus income.
Professional Advice: Because of the complexities surrounding inheritance tax and gifting rules, it's always wise to seek advice from a professional, such as Toucan Law.
Conclusion
Gifting surplus income is a smart and efficient way to reduce your estate's liability for inheritance tax. By making regular gifts from your surplus income, you can ensure that more of your wealth passes on to your loved ones rather than the taxman. However, it’s essential to follow the rules carefully, maintain proper documentation, and ensure that your gifts genuinely qualify for the exemption. With careful planning, you can use this strategy to its full advantage and make a meaningful difference to your beneficiaries.
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