For those building their wealth, contributing to pensions and ISAs will normally spring straight to mind. Those with assets outside of those valuable wrappers will usually know to think about Capital Gains Tax at this time of year. And, of course, there are potentially a whole myriad of available Income Tax allowances to consider.
But it is often easy to overlook that some Inheritance Tax advantages also expire at the end of the tax year. Read on for more details, including details of one of the most potentially valuable personal tax allowances that exists.
Inheritance Tax is a tax that applies to your estate when you die. It can also apply to some lifetime gifts made in the seven years before you die, and to specific types of trusts. The headline rate of Inheritance Tax is 40%, though there are various exemptions, allowances and reliefs. The biggest one is the nil rate band, which means the first £325,000 is taxed at 0%.
An introduction to the Inheritance Tax system and seven ways to potentially reduce your Inheritance Tax bill can be found in the Saunderson House Guide to Inheritance Tax Planning, available on request.
Annual Exemption – use it or lose it
Perhaps the best-known and one of the simplest ways to reduce your potential Inheritance Tax liability is by regularly using the so-called ‘annual exemption’.
This enables you to give away £3,000 of capital each tax year, and have this immediately fall outside of your estate, or become ‘immediately exempt’.
Immediately exempt means that, even if you died tomorrow, the gift would be completely ignored when calculating the Inheritance Tax bill, so there is an immediate potential Inheritance Tax saving.
Crucially, if you do not use this exemption, you can carry it forward for one tax year only. Any carried forward exemption is only used once you have fully used the current tax year’s exemption.
For the 2021/22 tax year then, if you didn’t use your annual exemption last tax year, you can make gifts of £6,000 of capital and save your heirs as much as £2,400 (perhaps even £3,600 in some special cases1) of Inheritance Tax later on down the line.
But, at this point, the 2020/21 annual exemption is use it or lose it – if you give away less than £6,000 in the above scenario, some or all of the 2020/21 annual exemption will expire on 5 April 2022.
The annual exemption has been frozen at £3,000 per tax year since 1981, back when £3,000 was worth a lot more: nearly £13,000 in today’s money, based on the Retail Prices Index or RPI measure of inflation.
Nevertheless, the value of the exemption should not be underestimated. A couple each giving away £3,000 a year for the last 30 years of their lives could save up to £72,000 of Inheritance Tax (perhaps even £108,000 in some special cases) – and that’s ignoring any investment growth.
You also do not necessarily need to limit your gifts to just the annual exemption. The annual exemption can be used as part of larger gifts, but you may need to survive seven years for the excess over the annual exemption to fall out of account.
Small Gift Allowance can make a big difference
Gifts of no more than £250 to other individuals are also immediately exempt, as long as you do not give the same individual more than £250 in the tax year.
This means that you cannot use the annual exemption and small gift allowance on the same beneficiaries, but otherwise you can give up to £250 to any number of beneficiaries each tax year using this ‘small gift allowance’.
So, every year, you could use your annual exemption of £3,000 on your children, for example, and then use the small gift allowance to make gifts of £250 to each of a growing brood of grandchildren, maybe even great-grandchildren, no matter their number.
You could even give £250 to each of your friends, neighbours, colleagues, acquaintances, if so inclined – there is nothing to limit the allowance to just your family. £250 a pop every year could quickly add up to a decent Inheritance Tax saving, depending on your popularity. In our experience, those giving away £250 every tax year are very popular.
So, before 5 April 2022, perhaps consider if there are others where that £250 small gift allowance might go a long way. This is another ‘use it or lose it’ allowance but, unlike the annual exemption, there is no ability to carry it forward to next tax year.
Closing time for the bank of Mum and Dad?
It is often overlooked that expenditure on the maintenance, education or training of a child under age 18 (or over age 18 but still in full-time education) is immediately exempt too. An Office of Tax Simplification survey in 2019 found that only 25% of respondents knew this.
Such expenditure also does not even count towards the aforementioned annual exemption. Nor would not count towards the small gift exemption for that matter, though good luck getting much maintenance, education or training out of just £250 these days.
As the end of the tax year approaches, it is worth bearing in mind that your ability to make immediately exempt gifts towards their maintenance may end on 5 April 2022, if:
Generous parents may wish to subsidise their adult children after full-time education, but if those gifts are made out of capital, and they have already used the annual exemption, then those gifts may only be fully outside of the Inheritance Tax net after seven years.
Regular gifts out of income – perhaps the tax code’s best-kept secret
So far we have focused primarily on gifts made out of capital, that is savings and investments that you have already built up over time. However, perhaps the least well-known way to mitigate your Inheritance Tax liability is to give away your income as you receive it, rather than saving or investing it yourself.
More formally, this is known as the ‘normal expenditure out of income’ exemption, with gifts being treated as an expenditure. As long as gifts satisfy the following three criteria, they are also immediately exempt, with no upper limit on their value:
This can be a particularly powerful benefit for those with larger incomes, such as those who are still working, perhaps at the height of their earning power but with a healthy nest egg already behind them, and those with a comfortable retirement income hitting their bank account every month.
For example, if you receive income of £100,000 after tax, but only spend £60,000 on your own usual standard of living, then you could gift away £40,000 each year and have this full amount be immediately exempt – far more than the annual exemption above (which you could also use, as that is for gifts of capital).
And yet, despite the enormous potential value of this exemption, HMRC estimates that among the 588,000 deaths in the 2015/16 tax year, only 579 estates (less than 0.1%) claimed that any gifts in the previous seven years before death fell under the ‘normal expenditure out of income’ exemption, with only 80 of those claiming more than £100,000.
The Office of Tax Simplification concluded in July 2019 that “the exemption for normal expenditure out of income is often not considered during lifetime and it only becomes apparent to the deceased’s executors after death that it may be available”.
It seems inevitable that enormous sums of surplus income are being accumulated within estates, that will never be spent, that could be passed on to future generations as and when received without any Inheritance Tax being due, but that instead is only eventually handed over on death, after the taxman has helped himself to a healthy slice, and all because taxpayers are not aware of the rules!
The only caveat to the above is that good record-keeping is required, to ensure that your executors are able to demonstrate that the gifts were out of surplus income rather than capital. But your financial advisers and accountants should be very much able to assist you with that.
Looking a gift horse in the mouth
HMRC estimated in 2019 that only 13% of individuals had made a gift in the prior two years, albeit that number rose to a still fairly modest 24% of those over age 70, 24% of those with incomes over £45,000 and 33% of those with a net worth over £500,000.
And at the same time, surveys repeatedly show that most people do not understand that they can save potentially life-changing amounts of Inheritance Tax by making gifts, well-advised clients of Saunderson House excluded of course.
Those who do make gifts are known to routinely comment on the sheer joy that it can bring them to actually see their generosity making a difference to the lives of others during their own lifetime, rather than cold hard cash only being handed over from beyond the grave.
So as the end of the tax year approaches, and with it some potentially valuable Inheritance Tax advantages expiring, is it time to consider (or reconsider) your gifting strategy?
Do get in touch with your usual Saunderson House contact if you have any questions on any of the content of this note. Our advice can provide you with the confidence that you can afford to make gifts without compromising on your other objectives, such as funding your retirement, and the ability to do so in the most tax-efficient way.
We are also experts in philanthropy, and can provide advice on charitable giving, including how this can be structured to achieve additional Income Tax and Capital Gains Tax benefits.
Please also do get in touch to request your free copy of the Saunderson House Guide to Inheritance Tax Planning. Besides gifting, there are six other ways to potentially reduce your Inheritance Tax bill.
1 If you leave a residence to direct descendants such as children or grandchildren on your death, your estate may be eligible for the Residence Nil Rate Band. This 0% band is tapered away by £1 for every £2 that your estate exceeds £2,000,000. This tapering effect can give rise to an effective Inheritance Tax rate of 60% on part of your estate. In some cases, this can be mitigated by lifetime gifts that result in an Inheritance Tax saving of up to 60%, rather than up to 40%.
This note is for general guidance only and does not constitute, and should not be construed as, investment advice or a recommendation to buy, sell, or otherwise transact in any investment activity. It represents our current understanding of law and HM Revenue and Customs practice as at 22/03/2022. We cannot assume legal liability for any errors or omissions and detailed advice should be taken before entering any investment activity. For further information, please contact your usual Adviser (or, in the case of new clients – please use our details and we will put you in touch with one of our Advisers).
Saunderson House, a wholly-owned subsidiary of Rathbones Group Plc, is authorised and regulated by the Financial Conduct Authority.
“An Office of Tax Simplification survey in 2019 found that only 25% of respondents knew this.”
“The Office of Tax Simplification concluded in July 2019 that “the exemption for normal expenditure out of income is often not considered during lifetime and it only becomes apparent to the deceased’s executors after death that it may be available””
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