How Christmas gifts to your family can help to beat inheritance tax – if you stick within the rules

Many grandparents, uncles and aunties will be looking to avoid the present-choosing minefield this Christmas by instead making financial gifts to their young relatives.

The majority of such gifts will not pose any inheritance tax questions as they will be covered by the exempt gifting rules, which set a number of limits on cash amounts that can be transferred each year without fear of attracting an IHT charge if the giver should die afterwards. In addition they can have the welcome consequence of reducing a future inheritance tax liability.

However, Ian Dyall, Head of Estate Planning at leading UK wealth management firm Evelyn Partners, observes that these have not changed in more than forty years:

'There was no IHT Christmas present from the Chancellor in the Autumn Statement after speculation that he would cut the rate or raise the nil rate band. In the absence of that, a very welcome stocking filler would have been to address these long-frozen gifting limits, but that didn’t materialise either.

‘So it’s very much “as you were” on the IHT front. The £250 per-person gift limit, which was set in 1981, would by this tax year have been around £910 had it risen with inflation, while the £3,000 annual total gifting exemption would now be about £10,920.[2]

'But exempt gifts do reduce the size of the gifter’s estate immediately, so even these amounts can still go some way to mitigating the IHT liability on smaller estates. A growing number of estates are finding themselves just the wrong side of the nil rate band (or tax-exempt allowance) of £325,000, which has been frozen for 14 years, so even modest lifetime gifts could come in useful as a way of saving executors and beneficiaries the rigmarole and expense of settling IHT before probate.[2]

'For those looking to make more substantial contributions to their younger relatives’ financial security, IHT might become more of an issue, as the seven-year rule then applies.'

On the one hand, large gifts can still be effective at reducing an estate’s IHT liability. If you live for at least seven years after making a gift of any size, then those funds - known as ‘potentially exempt transfers’ during that seven-year period – are counted as having left your estate.

Dyall points out that potentially exempt transfers can still reduce the overall IHT due on an estate even if the giver dies with seven years: 'The IHT rate on PETs that exceed the nil rate band reduces on a sliding scale as time elapses after the date of the gift, so that tax liability could still be reduced.' (See below for more detail on PETs.)

On the other hand, a big gift could leave a nasty surprise for beneficiaries who find that they owe tax on it if the gifter does die within seven years.

Dyall says: ‘Generally, the best time to gift, if you can afford it, is now.  The earlier you gift, the more chance there is of that gift becoming fully exempt, If the recipients want comfort in knowing that they can spend the money without worrying about an unexpected bill if the gifter dies, then they could use life assurance to cover that liability.’

He adds that while recipients of lifetime gifts might face unexpected IHT bills, gifting will only rarely increase the overall IHT liability: ‘This could for instance happen if the gifter has taken funds from an IHT exempt source, like a defined contribution pension pot, to make the gift.’

The good news is that, done properly, wealth transfers in lifetime can be advantageous on three counts: they can give the recipient a much-needed financial fillip, they allow the gifter the satisfaction and pleasure of making the gift, and they can also reduce the IHT that is payable on an estate when the giver dies.

‘Sharing wealth and helping loved ones financially is becoming even more of a priority as demands mount on the budgets of young families,’ says Dyall. ‘Passing on wealth during their lifetime also rewards the giver with the satisfaction of seeing the benefits being enjoyed. While it can in addition bring tax advantages, lack of familiarity with the rules could also be punished with tax penalties.’

The tax rules for financial gifts

Gifts of any value between UK domiciled spouses and civil partners are free from tax. Gifts to other individuals might also be untaxable as long as they meet the following conditions:

• Total gifts made by you in a tax year total less than £3,000 – or £6,000 for a couple. You can also carry forward any unused £3,000 allowance from the previous tax-year, making financial gifts of up to £6,000 possible this Christmas – or £12,000 for a couple.
• Small gifts of up to £250 can be made to any number of people in the tax year, provided the total to any one person does not exceed £250. If it does, this exemption does not apply and all gifts would start to use up the aforementioned £3,000 allowance
• Gifts out of regular income that are part of normal ongoing expenditure can also be made (see below for more detail)
• Money can also be given as a gift tax free in the event of a marriage or civil partnership amounting to £5,000 from each parent, £2,500 from each grandparent and up to £1,000 from any other person. These would not use up any of the other allowances.

Gifting from surplus income

'Regular gifts made by people with more income than they need may benefit from the ‘normal expenditure from income’ exemption,' says Dyall.

'This is a much-overlooked option for transferring wealth tax-efficiently, Many donors like to give ongoing regular amounts to young relatives, for instance into a savings or investment vehicle – such as a Junior ISA, pension or trusts.[3] But to be IHT-efficient, regular gifts must meet certain rules.

'To qualify, the gifts must be “regular” in nature, made from income rather than capital, and cannot affect the donor’s standard of living. This will not help if you only intend to make a one-off gift, but for those who are accumulating savings from excess income, gifting some each Christmas can be a tax-efficient way of helping younger family members.'

Seven-year rule and potentially exempt transfers 

Larger gifts can obviously be made – and without issue as long as the donor then survives for seven years. During that time such gifts remain ‘potentially exempt transfers’. If the donor dies within seven years, the nil-rate band is reduced by the value of the gifts (so in a sense they are counted as never having left the estate), and tax on assets above the NRB will be due at up to 40%.

We say ‘up to’ because if the gifts put together exceeded the nil rate band then taper relief can apply, which reduces the tax paid on older gifts. If there were three-to-four years between date of gift and death, the IHT rate lowers to 32%, while at six-to-seven years the rate falls to just 8%. All of which means that large gifts exceeding the nil rate band can moderate IHT liability even if they fall foul of the seven-year rule.[4]

But if a gift does become liable for IHT, it is the recipient who will have to pay, and they may not have the resources to meet a surprise tax bill when it arrives, possibly having spent the money.

A corollary of all this is, that if someone makes a gift of a value below the nil-rate band to one person, and then dies within seven years, then all the beneficiaries of the estate could share the liability on the lifetime gift received by one person.

The only time, in the main, that a donor will be subject to tax upon a gift during their lifetime would be if they made a gift to a discretionary trust, over the donor’s available inheritance tax nil rate band.

The use of trusts – and bare trust vs JISA

If your gift is not covered by an exemption, then all is not lost. After all, you can give away as much of your wealth as you like, and provided there is no continued benefit to you, the value will leave your estate after seven years.

However, most people will want to retain access to some or most of their wealth, not least in case emergency or late-life expenses, like care home fees, arise. They fear that if they gift away all their wealth, their relatives will spend the money unwisely, or render it inaccessible.

This issue can be addressed by using trusts – and two types are of particular interest.

A discretionary trust can allay some concerns that a beneficiary might squander assets, or lose them through divorce or a business insolvency – or simply to limit access until a child is of age. The beneficiary will be listed as one of several possible beneficiaries and will only benefit at the trustees’ discretion, so the trust can protect the assets, and the timing and size of any payments made from the trust can be controlled. Each person can gift up to the £325,000 nil rate band into discretionary trusts in any seven-year period without triggering an IHT liability. Gifts exceeding this will be immediately liable to IHT at 20% with further tax due if they die within seven years.

A bare trust can also be useful, particularly where grandparents wish to invest for grandchildren. When investing for minor beneficiaries, the natural instinct is to use tax-beneficial wrappers such as a Junior ISA, but these are limited in size and can’t be accessed before age 18, even for the child’s benefit,

If a grandparent invests for a grandchild using a bare trust, the invested amount is unlimited and money from the trust can be used for the child’s benefit before 18 if required. The investments are taxable, but it is the minor beneficiary who is liable, and their personal income tax and capital gains tax allowances usually eliminate any liability.

While bare trusts can be as tax efficient as a JISA but less limiting, anti-avoidance legislation does exist where the money is provided by a parent rather than a grandparent. If the income exceeds £100 the income is taxable against the parent. The JISA has a slight tax advantage for parental investments as they are not caught by these measures.

NOTES

[1] Calculated from 1981 to April 2023 using Bank of England inflation calculator.

[2] HMRC’s latest figures, for 2020/21, showed a 17% increase in the number of estates paying IHT on the previous year. For the Autumn Statement, the Office for Budget Responsibility increased its estimates for IHT revenues for the next five years. The Treasury is now forecast to collect £2.1billion more between 2022/23 and 2027/28 than was expected in the Spring Budget. The OBR is now predicting IHT will bring in £47.1billion for the Government over this period, compared to the spring estimate that the take would be £45.0billion. (OBR)

[3] Starting a pension for a child means they get basic rate tax relief, even though they may not be paying any tax. A gross pension contribution of up to £3,600 can be made for a child, meaning the parent or grandparent makes a subscription of £2,880 which is topped up by £720 by the government in tax relief. Investment growth and compound returns can make early gifting like this very powerful but access to the funds will be restricted by pension rules.

[4] Gifts under the nil rate band simply erode the nil rate band pound for pound for the whole seven years. It’s only if gifts in the seven-year period exceed the nil rate band that tapering has any effect. If the gift(s) exceeds the nil rate band then it creates a liability for the recipient, and their liability is eligible for taper relief.