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Inheritance Tax Gifts Out of Surplus Income: Navigating Exemptions and Regulations

Published on 
01 Jun 2024

In the context of estate planning, understanding the implications of inheritance tax on gifts can be crucial for efficient financial management. Inheritance tax is a charge on the estate of someone who has died, including property, money, and possessions. However, certain gifts can be made from surplus income, which may not count towards the value of the estate for inheritance tax purposes. Knowing how gifts out of surplus income work can provide a lawful means to pass on wealth without incurring a high tax liability.

A recipient generally must pay inheritance tax on gifts if the giver passes away within seven years of making the gift and the total gifts exceed the tax-free threshold. Nevertheless, the UK's tax regulations provide for exemptions when the gifts are made from surplus income. These gifts are considered outside of the estate for inheritance tax calculations, as they are regularly made out of income that is in excess to what the giver needs for their usual living expenses.

Key Takeaways

  • Inheritance tax applies to the estate of the deceased, encompassing assets such as money and property.
  • Gifts from surplus income can offer a tax-efficient way to pass assets to beneficiaries.
  • Understanding the rules and exemptions for such gifts is critical in estate planning.

Understanding Inheritance Tax Gifts

In the UK, when managing an estate, gifts made during a person's lifetime can impact the amount of Inheritance Tax (IHT) the estate may owe upon their death.

What Qualifies as a Gift

A gift for IHT purposes includes any asset or amount of money transferred to another person without an expectation of receiving full market value in return. Capital assets, money, or property passed on can all be considered gifts. Importantly, for it to be recognised as a gift for IHT purposes, the donor must no longer benefit from this asset; otherwise, it could still be considered part of the estate.

Gifts and the Inheritance Tax Threshold

The tax-free threshold, also known as the nil-rate band, is a key factor in determining whether an estate owes IHT. It currently stands at £325,000. Gifts exceeding this threshold may be taxed if they're given within seven years before death. Such gifts are potentially exempt transfers (PETs) — if the donor survives for seven years after gifting, the gifts will be exempt from IHT.

Exemption for Small Gifts

There are allowances for small gifts that don't count towards the nil-rate band. Each tax year, an individual can give away up to £3,000 worth of gifts — known as the annual exemption — without it being added to the value of the estate for IHT purposes. Additionally, small gifts up to £250 per person per year can be made to as many individuals as desired and are immediately free from IHT. These are immediately exempt and are not subject to the seven-year rule.

Gifts Out of Surplus Income

Inheritance Tax (IHT) planning often includes making use of gifts out of surplus income, which can offer significant tax benefits if managed correctly. This section outlines the key considerations individuals must be aware of when utilising this exemption.

Defining Surplus Income

Surplus income is the amount of income that remains after a person has met all their usual living expenses. It is paramount that the income is genuinely surplus to requirements, ensuring that one's standard of living is not diminished. The significance of surplus income arises in the context of Inheritance Tax, where certain gifts made from this income may not be liable for IHT.

Normal Expenditure Out of Income Rule

Gifts made regularly from surplus income can be exempt from Inheritance Tax as part of the 'normal expenditure out of income rule'. For a gift to qualify:

  • The gift must form part of the individual's normal expenditure.
  • It must be made out of income (not capital).
  • The individual should be able to maintain their usual standard of living after making the gift.

Regular payments such as annual family holiday contributions or monthly financial support to a family member can potentially qualify under this rule.

Record-Keeping for HMRC

Maintaining thorough records is essential to prove that gifts were made out of surplus income. HMRC may require evidence, such as submitted IHT403 forms or detailed financial records. Such evidence includes:

  • Bank statements
  • Income and expenditure summaries
  • Documentation of gifts made

Records should clearly show that the gifts were regular, came out of income, and did not affect the donor's standard of living. Consistent documentation reinforces the position that transfers were indeed normal expenditure from surplus income and eligible for IHT exemption.

Additional Exemptions and Taper Relief

When considering Inheritance Tax (IHT) in the UK, certain gifts may be exempt from tax or eligible for taper relief. These exemptions are specific and can significantly affect the IHT liability.

Wedding and Civil Partnership Gifts

Gifts given on the occasion of a wedding or the formation of a civil partnership can be exempt from IHT. The exemption limits depend on the relationship to the recipient: parents can each give up to £5,000, grandparents up to £2,500, and anyone else can give £1,000 tax-free.

Gifts to Charities and Political Parties

Donations to charities and political parties are typically exempt from IHT. There is no upper limit to this exemption, meaning any contribution that meets the qualifying criteria does not count towards the estate for tax purposes.

Seven-Year Rule and Taper Relief

The seven-year rule plays a pivotal role in determining IHT on gifts. If the donor passes away within seven years of making a gift, that gift could be subject to IHT. However, taper relief may reduce the tax rate on a sliding scale, depending on how many years have passed since the gift was made. For example:

  • Gifts made 3-4 years before death may have a taper relief of 20%,
  • for gifts 4-5 years before death, the relief increases to 40%,
  • and for 5-6 years, the relief stands at 60%. The taper relief reaches 80% for gifts made 6-7 years before the donor's death, thereby reducing the inheritance tax liability for the recipients.

Administering the Deceased's Estate

The administration of a deceased's estate involves the precise execution of duties, primarily by appointed executors or trustees, to ensure all assets are accounted for, valued, and distributed in accordance with the will or law. It's a process that includes serious legal and tax considerations, particularly regarding Inheritance Tax.

Role of Executors and Trustees

Executors and trustees are legally responsible for the collection and management of the estate's assets upon a person's death. They identify all the assets, which may include property, investments and personal belongings, and liabilities such as debts and mortgages that the deceased has left behind. Their role is to settle any debts, pay any taxes due and distribute the remaining assets to the beneficiaries as stated in the will. When assets are held in a trust, trustees must also manage these in the beneficiaries' best interest, adhering to the trust's terms.

Inheritance Tax Returns and Payment

Inheritance Tax (IHT) liability is a critical aspect of administering an estate. Executors must accurately calculate whether the estate owes Inheritance Tax, considering the tax-free threshold and any reliefs or exemptions such as gifts out of surplus income. They are required to complete Inheritance Tax returns using form IHT400 and supplementary schedules like IHT403 if the deceased gave away assets. Payment of any IHT due must typically be made within six months of the end of the tax year in which the death occurred. This process necessitates a comprehensive understanding of tax rules to ensure that the family's inheritance is maximised while complying with the law.

Frequently Asked Questions

The following are common queries regarding the documentation and tax treatment of gifts made from surplus income under UK inheritance tax regulations.

How can one document gifts made from excess income for inheritance tax purposes?

Individuals should maintain thorough records of their finances, indicating that the gifts were made from income not required to maintain their usual standard of living. Gifts must be properly accounted to support claims for exemption.

What conditions must be met for a gift to be exempt from inheritance tax under the surplus income rules?

For a gift to qualify, it should be made out of income that is excess to the donor's regular living costs and must be part of their normal expenditure. The donor should be able to maintain their standard of living after making the gift.

Which records are required when claiming gifts from income as exempt under the UK inheritance tax regulations?

Detailed records should include the donor's after-tax income, regular expenditure, and any gifts given. Evidence should adequately demonstrate that the gifts are made from income surplus to the donor's needs.

Can regular distributions from excess income be excluded from inheritance tax calculations?

Yes, regular payments that come from income surplus and do not affect the standard of living can be exempt from inheritance tax, provided they meet the necessary conditions set forth by HMRC.

What are the implications of inheritance tax on gifts made regularly from excess income?

Gifts from excess income can be immediately exempt from inheritance tax without the standard seven-year rule if they comply with the requirements for exemption under UK law.

How does HM Revenue and Customs classify gifts out of surplus income in relation to inheritance tax?

HMRC considers gifts from surplus income as those made from an individual's income left after all bills and usual costs are covered, which don’t affect their regular standard of living and can qualify for immediate IHT exemption.

Looking for expert, regulated and independent advice on your pensions? Assured Private Wealth can help. Get in touch today to discuss your pension planning or if you need advice on inheritance tax or estate planning.

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