Financial gifts and Inheritance Tax
Before looking at the seven-year rule, it’s important to know that certain gifts can be subject to Inheritance Tax – usually at a rate of 40%. HMRC has put in place a set of rules to prevent people from avoiding an Inheritance Tax bill by simply giving all of their money away on their deathbed.
Some gifts will usually be tax-free from the time they are made, for example, gifts between married couples or civil partners, regular gifts made out of excess income or the first £3,000 gifted in each tax year. Others could create a tax bill either immediately or in the future. You can find out more about these rules in our guide to making financial gifts.
The Inheritance Tax seven-year rule
Gifts to individuals that aren’t immediately tax-free will be considered as ‘potentially exempt transfers’. This means that they will only be tax-free if you survive for at least seven years after making the gift. If you die within seven years, the gift will be subject to Inheritance Tax. This is known as the seven-year rule.
Potentially exempt transfers reduce your nil rate band
If you die within seven years of making a potentially exempt transfer, the transfer becomes chargeable. Its value will either reduce or eliminate your nil rate band (the amount which can be passed to your beneficiaries without creating an Inheritance Tax liability), which is usually £325,000 per person. This means that less of your assets will be passed on to your beneficiaries tax-free.
Mrs Smith gifted £100,000 to her son in April 2015. When she died four years later in July 2019, her £1,000,000 estate also passed on to him. Because she died within seven years of making the gift, its value reduced her nil rate band.
This meant she could pass on £225,000 (£325,000 - £100,000) tax-free. The remaining value of her estate was £775,000 (£1,000,000 - £225,000). This was subject to Inheritance Tax at 40%. The total Inheritance Tax bill was therefore £310,000 (£775,000 x 40%).
Giving away more than the nil rate band
If you die within seven years of making gifts that exceed the nil rate band, your full nil rate band will be used up by the gift and there will be none left when it comes to passing on your estate.
On top of this, the recipient of the gift may need to pay Inheritance Tax on the value of the gift above the nil rate band. However, the amount of tax they will pay depends on how long you survive after making the gift.
What is taper relief?
The rate of Inheritance Tax they will pay gradually reduces over the seven-year period – this is called taper relief. It works like this:
How long ago was the gift made?
How much is the tax reduced?
More than 7 years
No tax to pay
It’s important to remember that taper relief only applies to the amount of tax the recipient pays on the value of the gift above the nil rate band. The rest of your estate will be charged with the full rate of Inheritance Tax – usually 40%.
Mr Jones gave his daughter £500,000 in July 2013. He died six years later in August 2019, leaving her the rest of his £700,000 estate. Because he gifted more than his nil rate band, his daughter had to pay Inheritance Tax on the excess when he died.
Inheritance Tax was due on the value of the gift above the nil rate band, which was £175,000 (£500,000 - £325,000). But because he died six years after making the gift, the amount of Inheritance Tax to pay was reduced by 80% due to taper relief. This meant rather than paying the full £70,000 (£175,000 x 40%), she only had to pay £14,000 (£70,000 x 20%).
As the gift had used up Mr Jones’s nil rate band, his entire estate was also subject to Inheritance Tax at the usual 40%. This meant that an Inheritance Tax bill of £280,000 (£700,000 x 40%) had to be paid before his assets could be distributed to his beneficiaries.
The 14-year rule?
These rules can get even more complex if you have made a series of gifts or gifts into certain types of trusts. In some instances gifts into trusts create immediate Inheritance Tax bills, and if you have made a series of gifts over time, then gifts up to 14 years prior to your death may affect how much tax is payable on those gifts! If you have made or are thinking about making gifts into a trust, you should speak to a financial planner first to find out if there could be any tax to pay further down the line.
Our financial planners can help you make financial gifts
Our financial planners spend their days helping people with estate planning and making financial gifts. They can show you:
- How much money you can afford to gift without running out later in life
- Whether you are due to leave behind an Inheritance Tax bill, and how best to manage or reduce this
- If your gifts could create tax charges for the recipients
- Whether you would be better off making outright gifts or setting up a trust
To find out how our financial planners could help you, please book an initial consultation online or by calling us on 020 7189 2400 . There is no charge – it’s just an opportunity to find out what they could do for you.
Examples of how tax or tax relief may apply are based on our understanding of current tax legislation. Whether any tax will be payable, at what level it is charged and whether you qualify for tax relief will depend upon individual circumstances and may be subject to change in the future.
This article was previously published on Tilney prior to the launch of Evelyn Partners.