Estate planning via gifting
Most gifts will fall under one of the following categories:
- Annual exemption – The first £3,000 gifted each tax year is immediately exempt from IHT. If unused, it can be carried forward to the next tax year, allowing for a maximum of £6,000.
- Small gift and wedding allowances – a further £250 per person per tax year or between £1,000-£5,000 for weddings (depending on who is getting married) is immediately exempt from IHT.
- Potentially Exempt Transfer – Any gifts to an individual or a simple trust (i.e. bare, fixed or absolute) is outside the estate for IHT purposes if you survive seven years.
- Chargeable Lifetime Transfer – Gifts to most other trusts and certain companies are immediately chargeable to IHT at half rate (20%) on gifts above the nil-rate band of £325,000. No further IHT charge is levied if the individual survives seven years, but it can increase the overall IHT charge for the estate up to 14 years later (the ‘14 year rule’). Periodic and exit IHT charges are also applied within the trust on an ongoing basis.
- Normal Expenditure out of Income – This allows for ongoing gifts of income to be immediately outside the estate if certain conditions are met.
One area that may be of particular interest to those considering gifting to mitigate IHT will be the normal expenditure out of income rules.
Normal Expenditure out of Income
Normal expenditure out of income (S.21 of the Inheritance Tax Act 1984) is a very useful inheritance tax exemption for estate planning. If a gift can be shown to meet the following three conditions, it will immediately be exempt from someone’s estate for IHT purposes:
- The gift must form part of the individual’s normal expenditure.
- It is made from income (taking one year with another).
- It leaves enough income to maintain their normal standard of living.
Normal expenditure - Normal is defined as including standard, regular, typical, habitual or usual. This means that there must be a pattern of ongoing gifting or evidence that this was the individual’s intention. Normal means normal for the individual, not for the average person.
Income – This is not defined and is therefore not necessarily the same as income for income tax purposes. Instead, it is determined in accordance with normal accountancy rules.
The phrase ‘taking one year with another’ is to provide for the case where a person’s income fluctuates from year to year, but overall they have enough income to make normal gifts and meet their standard of living on an ongoing basis.
Normal standard of living - The third condition is that, after allowing for the gifts of normal expenditure, the individual has enough income left to maintain their usual standard of living. Gifts, even when made from income, will not qualify if the individual had to resort to capital to meet their normal living expenses.
Case study - Nigel
Nigel (78) is divorced, with three children. He receives pension income (including state pension) of £30,270 gross per year, which is sufficient for his needs.
In terms of assets, he has a home valued at £450,000, a drawdown pension worth £300,000 and an ISA portfolio of £150,000.
Nigel intends to leave his home to direct descendants (his children) and £100,000 of his ISA portfolio is currently invested in AIM/unlisted shares qualifying for 100% business relief for IHT purposes.
This means Nigel would not currently have any IHT liability on death:
| Estate |
Pension | ||
| Total amount | £600,000 | Total amount | £300,000 |
| less IHT nil rate band | -£325,000 | ||
| less residence nil rate band* | -£175,000 | ||
| less business relief | -£100,000 | ||
| net estate subject to IHT | £0 | ||
*residence nil rate band available when main residence is inherited by direct descendant. Amount reduced by £1 for every £2 that estate exceeds £2.
What is changing?
Nigel is concerned that changes announced by the government could mean that he will now have a significant tax liability on death.
His adviser explains that the government has announced plans to half business relief on his AIM/unlisted ISA/GIA portfolio (from April 2026) and introduce inheritance tax on pension funds (from April 2027). Furthermore, IHT thresholds have been frozen until April 2030.
From April 2027, without allowing for any growth in the current value of his assets, Nigel is expected to have an inheritance tax liability of £140,000, as follows:
| Estate |
Pension | ||
| Total amount | £600,000 | Total amount | £300,000 |
| less IHT nil rate band (2/3 of £325,000)* | -£216,667 | less IHT nil rate band (1/3 of £325,000)* | -£108,333 |
| less residence nil rate band | -£175,000 | Net pension subject to IHT | £191,667 |
| net estate subject to IHT | £208,333 | IHT on net pension @ 40% | -£76,667 |
| IHT on £100,000** @ 20% | -£20,000 |
||
| IHT on £108,333 @ 40% | -£43,333 | ||
*nil rate band of £325,000 is to be apportioned between estate and pension.
**IHT on AIM/unlisted shares will receive 50% business relief, so IHT is 20%.
A possible immediate course of action
Nigel wants to consider what action he can take to mitigate this potential tax burden on his estate. However, he is uncertain how much money he needs for the future and is reluctant to make large gifts that might leave him with insufficient assets later on. He is also aware of the controversy surrounding these changes and that the final pension rules are still under consultation.
Nigel decides to:
- Take an additional £20,000 (£16,000 net) a year in pension income – this will increase his total income to £50,270, meaning he will remain a 20% basic rate taxpayer. He can gift this surplus income on an ongoing basis to his children which should qualify under the normal expenditure out of income IHT exemption. He will document that he intends to gift surplus income on an ongoing, regular basis (which ensures there is a clear audit trail to supply to HMRC, if ever challenged).
As it is not yet fully clear how pension/annuity death benefits will be taxed from April 2027, Nigel will initially use a fixed term annuity to generate the required income. At maturity, before the new rules take effect in April 2027, he can evaluate whether the income level should be adjusted, when he will have further clarity on the final pension rules. - Encash £50,000 of his ISA portfolio and reinvest in a bond held by loan trust – The segment of his ISA portfolio which doesn’t qualify for business relief will be fully chargeable to IHT at 40%.
Using a loan trust, alongside an investment bond, will ensure that any future growth in this money is immediately outside his estate. However, he will retain access to his original capital if he needs it. He can also be a trustee, retaining control of when his family can benefit from the funds.
Any repayments from the loan will be treated as return of capital. Therefore, Nigel cannot gift or rely on loan repayments to meet his normal living expenses (so that he can gift other income) under the normal expenditure out of income IHT exemption. However, he will be able to use his £3,000 annual IHT exemption to write off part of the loan each year.
These actions can reduce the size of his taxable estate by £69,000 by April 2027 (3 x £20,000 on the pension and 3 x £3,000 on the loan), and will avoid any tax due on growth in the bond and wider gifts.
Although these actions will only partially address his potential new £140,000 IHT liability, it allows Nigel to take advantage of his available allowances whilst awaiting clarity on the final rules. As things become clearer, he can then consider whether additional IHT planning (for instance, further use of trusts, increasing surplus pension income, or use of equity release) might be appropriate for his needs.
Comment
Many people have planned their finances with an aim of leaving a legacy for loved ones, often looking to spend other assets before pensions under the belief that this was the most sensible and tax efficient approach. These people may be worried by the announced changes and might want to act immediately.
Until there is clarity on the final rules, it is difficult to determine the most appropriate way to plan for these changes. However, gradually starting to use of some of the existing gift allowances each tax year could be a useful way for some people to begin to mitigate the impact until more is known. This may avoid more drastic immediate action that might later become an irreversible mistake.
Important information
Please note this is for general information only and is based on LV's understanding of the relevant legislation and regulations and may be subject to change.
The tax treatment of benefits depends on individual circumstances, and may be subject to change in the future.
The use of this document is at your own risk, and the content should not be used for the provision of professional advice.
LV= accept no liability for any damages, losses or causes of action of any nature arising from your use of this document.