Thu, 01 Mar 2018
Richard Mead, senior associate in the Inheritance Protection Team at Gardner Leader
Most people with an interest in Inheritance Tax are aware that they can give away up to £3,000 per year without any Inheritance Tax (IHT) consequences.
They also know that a larger gift is usually exempt from IHT if you live for at least seven years after making it.
However, there is another very valuable IHT exemption which is less well known.
This is the “normal expenditure out of income” exemption. In very general terms, regular gifts out of an individual’s surplus income are completely exempt from IHT as soon as they are made.
There is no requirement to survive seven years.
In the right circumstances, there can be scope to quickly achieve substantial IHT savings.
Income for these purposes includes non-taxable income from ISA accounts and investments, but does not include regular withdrawals from investment bonds.
For the exemption to be available, you must have surplus income after all regular expenditure has been deducted (for example, household expenses, the costs of running a car, holidays and income tax).
You have to make regular gifts, so this exemption won’t help if you can only commit to occasional gifts.
A grandparent with surplus income could utilise the exemption by paying school fees for grandchildren.
Surprisingly, there is no limit on the amount of exemption that can be claimed.
All that matters is that the gifts must continue for a reasonable period of time (typically several years).
After the gifts and income expenses have been paid, the donor must be left with sufficient income to maintain his or her usual standard of living.
A parent with two adult children and annual surplus income of £12,000 could make monthly contributions of £500 into an ISA account for each child.
If the parent died after five years, there would be an IHT saving of up to £24,000 (40 per cent of £60,000).
It is worth noting that the £3,000 annual exemption can be claimed on top of the normal expenditure exemption.
There is no requirement to notify HM Revenue & Customs (HMRC) when gifts from income are made.
However, after you have died your executors will have to formally claim the exemption for each of the seven tax years up to your death.
It is therefore vital to keep accurate records of income, expenditure and regular gifts.
If not, it is an almost impossible task for executors to try and compile this information retrospectively.
HMRC does not grant the exemption lightly, as often a considerable amount of IHT is at stake.
The relevant information should ideally be recorded on the HMRC form which the executors will eventually have to complete.
Spouses and partners should remember that they are treated individually for tax purposes.
It is therefore important for each individual to keep a separate record of income and expenditure. Gifts are best made from individual accounts rather than a joint account.
Sometimes an individual intends to make regular gifts but dies after one or two payments.
In these circumstances, HMRC will still allow the claim if there is evidence of an intention to make regular gifts.
It is therefore a good idea to record this intention in a letter or statement when the first gift is made.
The normal expenditure out of income exemption should always be considered at an early stage if you are in a position to make lifetime gifts.
It can be a very tax efficient way of transferring significant funds completely free of IHT.
For those individuals with substantial wealth, the normal expenditure exemption can be used alongside gifts of capital (which are subject to the seven-year rule).
Richard Mead, senior associate – inheritance protection. Telephone: 01635 293637. Email: firstname.lastname@example.org