Sharing your wealth and helping loved ones financially is a priority for many and more and more people are coming to us to discuss ways in which they can pass on their wealth during their lifetime and not just on their death. By making regular financial gifts during your own lifetime, your loved one gets financial support at a time when they really need it and you get to see them benefit from your money.
What is surplus income?
As the name suggests, surplus income is any remaining income you have after all of your outgoings have been paid. If you regularly have income left over which is surplus to your own needs and has no bearing on your standard of living, you might want to consider using this money to provide a regular financial gift.
While this concept is relatively straightforward, it can be a bit more complicated when it comes to thinking about what monies are classed as income. Your income includes earnings from employment and pensions, but it can also include interest, dividends and rental income. There are a number of investments which produce regular payments which are often thought of as a form of income, but in fact, they’re not. Two of the most common examples of this are regular withdrawals taken from a life assurance bond and if you have a purchased life annuity (i.e. it was not purchased with pension funds and was bought through other sources). Only part of the annuity will be considered as income and the remainder will be a return of your invested capital, as will all the withdrawals made from life assurance bonds.
How do I make regular financial gifts?
Once you have established that making a regular financial gift from your surplus income will not have an impact on your lifestyle, the simplest way to make these gifts is by setting up a regular standing order directly into the recipient’s bank account.
Alternatively, you might want to set up some sort of policy for the recipient, such as a life insurance or pension plan, and you could pay the regular premiums out of your surplus income.
What are the rules around making regular financial gifts?
When it comes to giving regular financial gifts, there are three important rules that you need to follow:
- The gifts must be made out of your income
- They form a part of your ‘normal expenditure’ and are paid out on a regular basis
- The payments should not have any impact on your own standard of living.
Why is it important to follow these rules?
If you die within seven years of making a financial gift, either your estate or the recipient of the money may be liable to pay Inheritance Tax on your death, depending on the total value of the gifts you have made in the seven years prior to your death. This is commonly referred to as the seven year rule.
However, if the regular gifts follow the three criteria outlined above, on your death, the regular gifts will be covered by the ‘normal expenditure out of income’ exemption. This means that the gifts will be exempt from Inheritance Tax and neither the recipients nor the estate will pay tax on these gifts.
This is especially important for many donors as their loved one may not have the money available to pay the Inheritance Tax bill and most people want to make sure that the people who matter the most to them wholly benefit from their hard-earned money.
How do I qualify for the normal expenditure out of income exemption?
It’s important to think about what is classed as ‘normal expenditure’, as this is one of the most commonly tested elements of estates which go to court after a donor’s death. It’s a bit of a grey area as there is no legal definition of what normal expenditure actually is.
For the purposes of qualifying for the exemption, normal expenditure means what is usual for the donor based on their individual circumstances, and not necessarily what is usual for the average person. Regularity is key to this, as by establishing regularity, it helps to prove that the gifts formed a part of your normal expenditure.
There are some exceptions here. If you start to make regular payments to someone but you don’t survive for long enough to establish a pattern of regularity, as long as HMRC can establish that the gift was going to be made regularly, it may still be classed as a part of your normal expenditure for Inheritance Tax purposes. Also, while establishing regularity is important, HMRC does recognise that the amount paid to you via some income sources is variable (such as dividends from an investment) and that some regular costs may change too, for example, school fees. The value of the gift may vary due to these factors.
How do I claim the normal expenditure out of income exemption?
After your death, the executors of your estate will need to complete a table on HMRC’s Gifts and other transfers of value (IHT 403) form. It is designed to show HMRC your net income versus your net expenditure for the year they are claiming you made the regular gift. This will also confirm if there was any surplus income available.
It can be really difficult for the executors to document this information unless you keep a record of it yourself. I would suggest that the simplest way to do this would be to complete the table every year. If you plan to start making regular gifts, it might be a good idea to state in writing (perhaps via a letter) your intentions as if you die just after the regular payments have started, HMRC may still allow the exemption.
How Evelyn Partners can help
Our experts help people with estate planning and making financial gifts. If you would like to speak to a financial planner for more information, we can offer a free telephone consultation. Although we can’t give you advice during this initial stage, we can offer information, let you know if we think you would benefit from our personalised service and explain the potential costs involved. You can book a free consultation online or call us on 020 7189 2400.
This article was previously published on Tilney prior to the launch of Evelyn Partners.