A clever way to escape inheritance tax

by Saran Allott-Davey on 18 June 2010  |  4 comments
Tweet

Saran Allott-Davey of Heron House Financial Management explains how to protect more of your money from inheritance tax.

Guest blogger Saran Allott-Davey of Heron House Financial Management explains how to protect more of your money from inheritance tax.

Raising the Inheritance Tax (IHT) threshold to £1 million was trumpeted in the Conservative’s manifesto but doesn’t appear to have survived the post-election excitement of coalition politics.

Given the size of the public debt, it’s likely to be a while before IHT issues become a priority, so the best policy looks like being making the best of what you have.

Tackling inheritance tax

One of the least understood aspects of IHT is the very useful distinction between gifts out of capital and gifts out of income. It's well known that you can give away up to £3,000 in each tax year and it will be exempt from IHT plus small gifts of up to £250 to as many people as you like.

There are also special allowances around weddings and civil ceremonies. You can give away larger gifts of capital which will be treated as a Potentially Exempt Transfer and so will be out of the donor’s estate after seven years (assuming the doner survives for this period).

Gifts out of income

But I want to focus on the less well known rules surrounding gifts made out of income.

A gift is treated as being made out of income if it is regular and doesn't restrict the donor’s lifestyle. If these conditions are met, the gift is treated as immediately outside the estate.

In practive, if your after tax income is say, £30,000 a year and your outgoings are £25,000, then the balance can be gifted each year with no IHT implications. Gifts that exceed the balance will be treated as a gift from capital, so the normal IHT allowances or seven-year Potentially Exempt Transfers rule will apply.

Recent question on this topic

• toyraman asks:

  What is the tax positon of non earning child who receive money as gift from parents?

  • 
    champ69 answered "childs age ?..."
  • 
    manzanilla answered "I assume the child is under 18. this pages explains it all..."
  • Read more answers

Why make a regular gift?

There are some practical points to bear in mind. Gifts made on a monthly basis establish regularity much quicker than, say, annual gifts. And you have control since these gifts can also be varied or stopped.

A key point here is that the donor needs to keep good records in order to rely on the exemption at a later stage. These include bank statements detailing the gifts and a note each year of the difference between total living expenditure and income which shows the value of gifts that can be made free from IHT.

Ideally this needs to be structured to reflect the information needed when executors of the will come to fill in the estate record (HMRC form IHT403).

Income can be from any source - annuities, pensions, interest, dividends, earnings or rental income. An exception is investment in life assurance bonds because for tax purposes the ‘income’ received is generally treated as a repayment of capital.

The person receiving the gift doesn't have to declare it for tax purposes. But in the event the donor’s estate was unable to meet its will liabilities, the receiver could be required to meet IHT on the gift.

Is it complicated?

There doesn't have to be trusts or complex financial structures involved. Making gifts out of income could help reduce the value of estate more quickly by allowing higher gifts. But this approach also has income tax implications for the donor so the overall situations needs to be considered.

That said, most donors like this strategy. They can retain some control over the money they want to give, and can allow it to be used for worthwhile purposes such as school fees, mortgage payments or pension contributions for children or grandchildren.

But probably most important of all in the context of inheritance planning, they have the very real satisfaction of still being alive to see the gifts making a positive difference to family or friends.