To gift, or not to gift? When Inheritance tax is the question!

There is not a week that goes by here at Capital without a client contacting us, wanting to help family or friends with a cash gift. It’s great to assist our clients to do this and shows what a generous group of people you are! 

Often, before we begin to look at where the money should come from, or how quickly we can raise it, a common question we get asked is “Can we do this, I’m  not sure we can because of inheritance tax?” 

Reflecting on this, I suppose we only really think about inheritance tax (IHT) when we are about to gift, or if we, or our elders are in our later years. It could well be this tax becomes more relevant when we gain a few more grey hairs and until then, it remains an enigma. 

There is a common misconception that you cannot gift freely for fear of the dreaded inheritance tax, but this tax is widely misunderstood when it comes to gifts. I do sympathise, the rules are unclear and complex when the gifts become large, so I hope this note clarifies what you can do and explains when and if an inheritance tax charge arises. 

First things first, let us look at what you can do freely and without worry. The following assumes you are gifting to other people (not a Trust.) The technical name for these IHT free gifts is ‘exemptions’. 

Normal expenditure out of income (gifts from income)

Put simply, if you are gifting out of your surplus income, the gift should be free from IHT. There are three criteria to satisfy. You must prove your income is greater than your expenses. After making the gift your income still covers your normal standard of living. The gift now forms part of your normal expenditure going forward, it was not a one-off. 

Let us look at an example:

Suzie earns £80,000 a year after tax. This is made up of salary, rental income, and interest on her cash-ISA. She spends £60,000 a year. She has shown £20,000 of excess income. Being prudent Suzie keeps some excess income for herself, but she wants to fund a Junior ISA for each of her two nieces, investing £500pm each until they reach age 18. 

As this is a gift from surplus income, it is regular in payment, and does not restrict her standard of living, her £12,000 a year gift is exempt from IHT on her death. 

A couple of points to note. This exemption is for surplus income only, not transfers of capital or valuables. Gifting, say, a one-off jewellery item, a car, or a portfolio of shares does not qualify for this exemption. For that we need to look at lifetime gifts of capital or assets. 

Lifetime gifts    

There are several lump sum gifts that are exempt from IHT. The main ones are:

• Annual gift exemption -£3,000 each year.
• Small gift exemption – £250 a year to any number of people.
• Gifts in consideration of marriage or civil partnership – limits apply to the exemption. £5,000 from each parent, £2,500 each grandparent, and £1,000 from any other person.
• Gifts for education and maintenance – transfers to a current or former spouse or a dependent relative and payment of child maintenance is exempt, with no limit.

Exempt gifts made during lifetime or on death.

The following gifts of capital or assets are typically exempt from IHT.

• Gifts between UK domiciled spouses (special rules apply for non-domiciled spouses.)
• Gifts to charities or political parties.
• Gifts for national benefit – gifts to museums, universities, libraries, National Trust.

What about larger gifts?

As is sometimes the case, clients do occasionally need to make larger gifts than these exemptions allow and here lies the question over inheritance tax. 

The ‘7-year rule’.

No IHT is due on gifts if you live for 7 years after giving them. This is known as the 7-year rule. If you die within 7 years, there could be IHT to pay on it as the amount depends on when you gave it. 

Gifts made in the 3 years before your death are taxed at 40%. Gifts made in year 3 to 7 are taxed on a sliding scale, known as ‘taper relief’. 

However, taper relief only applies if the total value of gifts made in the 7 years prior to death is over the £325,000 tax-free threshold, known as the ‘nil rate band’.

It’s worth pausing here to reflect on this. If your gift is over the £3,000 annual exemption but under the £325,000 nil rate band, there is no actual tapering, the gift is part of your estate for 7 years. Your inheritance tax situation is therefore neutral. Whether you make the gift or not, your IHT is going to be the same until you hit the 7-year mark. 

The estate therefore pays any inheritance tax that is due on that gift.

Record Keeping

The people dealing with your estate will need to work out what gifts have been made in the 7 years before death. It’s recommended that a record of all gifts is kept to help them with this task.

Ok, so when is IHT paid on a gift then?

If you have given away more than £325,000, the person who received the gift may have to pay IHT on their gift if you died within 7 years.

The best way to show this is to use an example.

Frank died on 1^st March 2023. He made three gifts before he died to his two siblings. He wanted to treat them equally and so gave them both £325,000. 

• GIFT 1               £100,000 to his brother 8 years before he died.
• GIFT 2               £325,000 to his sister 4 years before he died.
• GIFT 3               £225,000 to his brother 2 years before he died.

There is no IHT to pay on Gift 1 as it was given to his brother more than 7 years ago.

There is no IHT to pay on Gift 2 as this gift is within the £325,000 IHT threshold. 

There is IHT to pay on Gift 3. Franks brother has a 40% IHT liability on his £225,000 gift as his sister used the threshold 4 years ago. The tax due is £90,000. 

Over Frank’s lifetime, his sister received £325,000 and paid no tax. His brother received £325,000 but paid £90,000 tax. Unfortunately, Frank did not achieve the equality he had hoped. 

Frank’s remaining estate was valued at £600,000. The estate would pay IHT of 40% on £600,000. The tax situation was therefore:

• Frank’s sister received £325,000 and paid no tax.
• Frank’s brother received £325,000 and paid £90,000 tax.
• The estate received £600,000 and paid £240,000 tax.

Advice

If you are looking to make gifts or wish to consider gifting as an IHT mitigation strategy, it’s worthwhile taking advice from your Financial Planner, solicitor, or accountant on the potential IHT impact on you, your estate, and the person you are gifting the money to. 

HMRC took a record £7.8 billion of inheritance tax in 2022 and whilst they argue that 94% of estates do not pay the tax, for those that do, the tax can be quite sizeable. 

If in doubt, let’s have a chat. We’re here to help. 

Graham McCulley
Director
Chartered Financial Planner