Why you should give away surplus income

Few of us actually want to give away our money. But the fact has to be faced, the time will come when we have no further need for it, and when that time comes, we would rather it went to our loved ones rather than the taxman.

The taxman, of course, has other ideas.

The problem is inheritance tax (IHT). Soaring property prices and frozen tax thresholds push thousands of families through the tax-free allowance, and into paying 40% on the wealth they expected to inherit.

If you leave an estate that is worth more than the £325,000 allowance – called the nil-rate band – anything above this threshold will be subject to IHT, charged at 40%.

The number of people who pay the 40% IHT charge is expected by the Office for Budget Responsibility to rise from around 40,000 this year to almost 50,000 by 2027. 

Fortunately, if you are at risk of paying IHT, there are plenty of things you can do to slash your bill, and one of the most lucrative is the “gifts out of surplus income” rule. 

The rules on giving it away

The more there is in your estate, the more tax will be taken from it. But if you reduce the size of your estate, there is less for the taxman. The simple way to do this is by giving wealth away to those who would receive it when you are gone – but by doing it while you are still alive.  

You can give your money to whoever you want, whenever you want (it’s your money after all) But the taxman knows that people nearing their end would rather give their money to anybody else but him. 

There are therefore rules on gifting. The most important is the one designed to prevent ‘deathbed giving’. Money you give away will still be included in your estate for tax purposes, unless you live for another seven years. 

The taxman will claw gifts back from those you have been generous to.

But there are some exceptions. Taxpayers get a £3,000 annual IHT exemption, as well as a £250 small gifts allowance.  You can also give £5,000 to a child or £2,500 to a grandchild for wedding expenses. But if you want to give more than this, the seven-year rule will usually apply. 

But there is another exception. The seven-year rule does not apply to gifts made from excess income.

Excess income is disposable

This rule allows any taxpayer to give away unlimited sums of money (obviously, while they are alive) without getting caught by IHT – as long as the gifts do not diminish quality of life and come out of income, rather than capital. 

You can give away income – from employment, property, pensions, interest and dividends – but not capital assets such as securities or jewellery. 

This means you can give as much as you like without worrying about the seven-year rule, as long as the gifts meet certain criteria.

  • Gifts must be “normal expenditure” – which means they should be regular. HMRC will look back over at least three or four years to see if gifts are made on a regular basis.
  • Gifts must come out of income – employment, dividend or pension income – and not capital. 
  • Gifts must not diminish your standard of living – you should be able to afford the gifts once you have paid your normal outgoings.
  • Gifts must be of the same size – However, the taxman will accept gifts of different sizes if your income is variable or if the gifts cover costs that are variable, such as school fees. 

But be careful…

HMRC have rules, regulations and practices to try to curb misuse of the gifts out of surplus income concession.

The taxman will look at your income in the year the gift was made to see if it was affordable. He will also check that you meet your ordinary standard of living after making the gifts and look at your income and outgoings.

This means that there is a fair amount of interpretation to be done, which to be fair can work both ways. The taxman may even OK a gift of a capital asset if it has been bought using income and specifically for the recipient, as long as it falls into the normal pattern of giving. A gift of jewellery or a car may qualify on this basis while personal goods, securities or a share in a business would not. 

Getting help to claim the tax break

It is your executors who will have to claim the exemption when they come to fill in the IHT forms. They will need strong evidence in to claim. 

This is why it is vital that you keep good records of your gifts, income and outgoings for the relevant years. 

You also need to consider gifts out of surplus income as part of your overall strategy for minimising IHT. It is a complex area, and expert help is essential – and at Continuum, we can provide it, as part of our tax planning expertise.

To start working on a strategy that will keep more of your wealth for those you care about rather than the taxman, call us today.

Pass on unlimited amounts to your children – and never pay inheritance tax (telegraph.co.uk)

The information contained in this article is based on the opinion of Continuum and our understanding of current HMRC tax rates and does not constitute advice on a suitable Inheritance tax strategy or investment strategy, you should seek independent financial advice before embarking on any course of action.

The Financial Conduct Authority does not regulate taxation and trust advice or will writing.

Levels, bases and reliefs from taxation are subject to individual circumstances and may be subject to change.

We recommend that you seek professional advice on personal taxation matters.

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